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Debt Service

Article ID: 253
Last updated: 21 Sep, 2014
Revision: 2
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By Jason Watson ()
Posted September 2, 2014

This is a big deal, and it is often overlooked. We have seen too many business acquisitions fail because the buyer did not get quality advice on debt service. Let’s look at two common scenarios that need to be avoided. First is the asset-heavy acquisition-

Fixed Assets 1,000,000
Income x 3 Years 450,000
Purchase Price 1,450,000
Down Payment 145,000
Financed 1,305,000
Payment (15 Years, 5%) 10,320
Annualized Payments 123,838
Annualized Income 150,000

In this scenario, a buyer would need to have a considerable down payment to make the cash flow provide for debt service plus owner compensation. This was a real case we dealt with recently, and the buyer couldn’t stomach working for $16,000 per year for 15 years.

In the second scenario, the fixed assets are small but the terms offered by the seller were onerous in terms of loan length-

Fixed Assets 10,000
Income x 3 Years 90,000
Purchase Price 100,000
Down Payment 10,000
Financed 90,000
Payment (15 Years, 5%) 1,698
Annualized Payments 20,381
Annualized Income 30,000

This too was a real case. And in this case, the buyer decided that she did not want to take on the business only to clear $9,500 per year. It wasn’t worth the work in her opinion.

In both of these situations the acquisition would have paid for itself from a cash flow perspective. Let’s say that the owners in both situations were also able to justify working for the incremental leftover cash ($16,000 in the first scenario, and $9,500 in the second scenario). This only looks at cash.

From a tax perspective, it will be even less attractive since a portion of the annualized payments will be principal reduction which is NOT a tax deduction. So, while your net cash might be $16,000 in the first example you might actually pay taxes on a higher number such as $80,000 (especially in the later years). $80,000 at 25% marginal tax rate becomes a $20,000 tax bill for $16,000 in net cash. Now you are upside down by $4,000, and hopefully future growth can pay for it.. hopefully.

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