IBA, as the premier business brokerage firm in the Pacific Northwest, is firmly established as a respected professional service firm in the legal, accounting, banking, mergers & acquisitions, real estate, and financial planning communities. Periodically, we will post guest blogs from professionals with knowledge to share for the good of owners of privately held companies & family owned businesses. The following blog article has been provided by Seth Rudin and David Bruder. Mr. Rudin is a senior business broker at IBA (www.ibainc.com). Mr. Bruder is a SBA Relationship Manager/Banker at Northwest Bank (www.northwestbank.com).
Understanding Business Valuation Multiples and Bank Financing Ratios
It is common for our team to engage with buyers who confuse the multiples for the valuation of a business’ enterprise value with the risk ratio banks often use called the Debt Service Coverage Ratio (DSCR). In a recent transaction, a buyer tried to convey that the bank’s multiple of 1.5 was the upper limit they would offer to buy the business because that is what the buyer mistakenly (or opportunistically) claimed the bank valued the business. The bank simply gave the buyer a ratio of the business’ income vs. the debt service amount.
Mr. Bruder and Mr. Rudin describe below how these two critical ratios should be interpreted and applied in a business sale.
Understanding Bank Financing vs. Valuation Multiples: Don’t Mix Them Up
Using “multiples” in a business sale transaction refers to one of the approaches for business valuation. M&A leverages ratios of a financial metric such as Revenue / EBITDA to a Sale Price of one or multiple similar transactions to determine the value or terms of a business sale.
For example, if a business “Newco” generated $10,000,000 in revenue and realized Earnings Before Interest, Taxes, Depreciation and Amortization (“EBITDA”) of $1,500,000 and sold for $5,00,000, then Newco had a revenue multiple of 0.5 ($10,000,000 x 0.5 = $5,000,000) and an Earnings multiple of 3.3 (3.3 x $1,500,000 = $5,000,000).
Investors, buyers, and appraisers also commonly use this approach to ensure fair pricing, evaluate investment opportunities, or make competitive offers.
When buying a business, it is easy to become overwhelmed by financial jargon. Buyers often confuse business valuation multiples and the debt service coverage ratio (DSCR). However, these concepts are vastly different and serve distinct purposes.
Valuation multiples are used to determine how much a business is worth based on others in the same industry.
DSCR is a tool that banks use to assess a buyer’s ability to repay a loan.
Understanding the difference between these is critical to making informed decisions during the purchase process.
What Are Valuation Multiples?
Valuation multiples like EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) and SDE (Seller’s Discretionary Earnings) are industry-standard methods used to calculate the value of a business.
For example, if a prospect business has the following attributes:
- EBITDA: $1,500,000
- SDE: $1,700,000 (this includes $200,000 of owner compensation added back to EBITDA)
If businesses in the same industry sell for a 3x multiple, the sales price would be:
- SDE valuation: $1,700,000× 3.0 = $5,100,000
These multiples are benchmarks based on comparable business sales, market trends, and conditions.
What Is the Debt Service Coverage Ratio (DSCR)?
The DSCR is NOT about valuing the business. It is a measure banks use to evaluate risks, specifically, whether the income from the company can cover the loan payments.
Using the Example Above:
If the buyer uses the SDE valuation of $1,700,000 and finances 90% of the purchase:
- Purchase Price: $5,100,000 (Final negotiated purchase price)
- Down Payment (10%): $510,000
- Loan Amount: $4,590,000
With an 8% interest rate over 10 years, the annual loan payments (debt service) would be $668,272 ($55,689 monthly).
To calculate the DSCR:
The Bank will request the Buyer to provide their plans for paying themselves to replace the seller’s responsibilities for operating the business. In this case, the buyer feels that $250,000 a year is an adequate compensation for these duties.
- Business Income (Adjusted SDE): $1,700,000
- Subtract $250,000 to replace the owner’s salary = $1,450,000
- DSCR = $1,450,000 ÷ $668,272 = 2.23
What Banks Look For:
- A DSCR of 1.15 or higher is usually required.
- Conservative banks may require 1.5 or more.
Why Buyers Confuse These Concepts
The confusion often arises because both DSCR and multiples deal with income—but for entirely different purposes:
- Valuation multiples determine how much the business is worth.
- DSCR determines whether the buyer can afford to borrow money to buy the business.
Understanding these distinctions will save you time, money, and stress. With the right expertise and preparation, you can confidently navigate the financial side of buying a business and focus on achieving your goals.
If you have questions relating to the content of this article or the process associated with selling a business in Washington or Oregon, Seth Rudin would welcome the opportunity to talk with you. Mr. Rudin is licensed to sell businesses & real estate in both Washington and Oregon. Mr. Rudin can be reached at (425) 454-3052 or seth@ibainc.com. If you have questions related to financing the acquisition of a privately held company or family business, David Bruder would welcome the opportunity to talk with you. Mr. Bruder can be reached at (206) 621-8712 or david.bruder@northwest-bank.com.
IBA, the Pacific Northwest’s premier business brokerage firm since 1975, is available as an information resource to the media, business brokerage, mergers & acquisitions, real estate, accounting, legal, and financial planning communities on subjects relevant to the purchase & sale of privately held companies and family-owned businesses. IBA is recognized as one of the best business brokerage firms in the nation based on its long track record of successfully negotiating “win-win” business sale transactions in environments of full disclosure employing “best practices”.