How to Read a Borrower's Financials Like a Pro

Guys, here's the deal. If you can't read a P&L, a balance sheet, and a personal financial statement with confidence, you are guessing. And guessing in SBA lending gets you dead deals, frustrated borrowers, and lenders who stop returning your calls.

I've been analyzing financials for SBA deals for over 25 years. The pattern I see over and over is the same: an originator gets excited about a deal because the top-line revenue looks great, the borrower is enthusiastic, and the business sounds solid. Then the financials hit the lender's desk and the whole thing falls apart. The DSCR doesn't work. The add-backs are aggressive. The personal financial statement shows the borrower is underwater. Somebody should have caught all of this before the package was submitted. That somebody is you.

Financial analysis isn't about being a CPA. You don't need an accounting degree. What you need is the ability to look at a set of financials and quickly determine: does this deal have legs, or am I about to waste forty hours of work? That's the skill this article builds.

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The 5 C's Framework

Before we get into specific financial statements, you need a framework for how lenders evaluate deals. The 5 C's have been around forever because they work. Every credit officer, whether they call it by this name or not, is evaluating your deal through these five lenses.

Cash Flow. Does the business generate enough money to cover the new loan payment plus all existing obligations? This is the most important of the five. A business with mediocre credit, thin collateral, and limited capital can still get approved if the cash flow is overwhelmingly strong. A business with perfect credit and tons of collateral but negative cash flow is dead on arrival. Lenders measure this with the DSCR — debt service coverage ratio — and we'll get into the math below.

Credit. The borrower's personal credit history. Most SBA lenders want a FICO of 650 to 680 as a minimum, though some go lower with strong compensating factors. Below 620, you're fighting an uphill battle. Credit tells the lender how the borrower has managed financial obligations in the past, and past behavior is the best predictor of future behavior. That's the lender's thinking, right?

Collateral. What assets can the lender secure the loan against? In SBA lending, full collateral coverage isn't required — the SBA explicitly states that no loan should be declined solely for lack of collateral. But lenders still take what's available: business assets, equipment, real estate, and personal assets if the loan exceeds $500,000. The collateral position affects the lender's recovery in a worst-case scenario, and it influences their willingness to approve borderline deals.

Capital. This is the equity injection — what the borrower is bringing to the table. The SBA minimum for acquisitions is 10% of the total project cost. Many lenders want more. This is what Steph calls the "number one killer of small business" — not collateral, not credit, but equity. The number of deals I've seen die because the borrower showed up with 5% down on a $2 million acquisition is staggering.

Character. The borrower's background, experience, and personal history. Relevant industry experience matters enormously in SBA underwriting. A buyer with 15 years of management experience in the same industry as the target business is a fundamentally different risk than a buyer with no relevant experience. Character also includes criminal history, prior government loan defaults, and the overall impression the borrower makes on paper and in person.

The 5 C's aren't a checklist where you need all five to be perfect. They're a balancing act. Strength in one area can compensate for weakness in another — up to a point. A lender might accept lower credit if the cash flow is exceptional and the equity injection is above the minimum. But there are limits. No amount of collateral makes up for a business that can't service the debt.

For a full picture of how these factors interact in acquisition deals, see our SBA Deal Structuring Guide.

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Reading a P&L for SBA Purposes

The profit and loss statement — also called an income statement — tells you what the business earned and what it spent over a specific period. For SBA purposes, lenders typically want to see three years of P&L history (usually from tax returns) plus a year-to-date interim statement.

Here's what you're looking for as an originator:

Revenue trends. Is revenue growing, flat, or declining? Three years of growth is ideal. Flat revenue is workable. Declining revenue is a red flag that triggers additional scrutiny. If revenue dropped 15% year-over-year, the lender is going to want to know why, and "COVID hangover" stopped being an acceptable answer two years ago.

Gross margins. Revenue minus cost of goods sold, divided by revenue. This tells you how efficiently the business produces its product or delivers its service. Margins that are shrinking year-over-year suggest pricing pressure, rising input costs, or operational inefficiency. The lender will compare the business's margins to industry benchmarks.

Owner compensation. This is critical. How much is the owner paying themselves? Some owners suppress their salary to inflate bottom-line profit and make the business look more profitable than it is. Others overpay themselves, which is actually better from an SBA perspective because that excess compensation becomes an add-back (more on this below). You need to know what a reasonable owner salary looks like for the industry and business size.

Discretionary expenses. Personal vehicles, travel, meals, family members on payroll who don't actually work in the business. These are the expenses that an SBA underwriter will evaluate as potential add-backs — costs that inflate the P&L's expenses but wouldn't necessarily continue under new ownership.

One-time or non-recurring items. A lawsuit settlement, a major equipment write-off, an insurance payout. These skew the financials in one direction or the other and need to be identified so the lender can assess normalized earnings.

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Add-Backs: What Counts and What Doesn't

Add-backs are the adjustments made to the business's reported earnings to arrive at the actual cash flow available for debt service. This is where financial analysis gets real, because the difference between reported net income and adjusted cash flow can be massive.

Commonly accepted add-backs:

• Owner's excess compensation. If the owner pays themselves $250,000 but the market rate for a replacement manager is $100,000, the $150,000 difference is an add-back.
• Depreciation and amortization. Non-cash expenses. They reduce taxable income but don't represent actual cash leaving the business.
• Interest expense on debt being refinanced. If the SBA loan is replacing existing debt, the old interest payments get added back.
• One-time expenses. Legal settlements, major repairs that won't recur, moving costs, rebranding expenses.
• Personal expenses run through the business. The owner's personal car, personal travel, family member salaries for no-show employees. These are common in small businesses and legitimate add-backs — but they need documentation.

Add-backs that will get challenged:

• Aggressive revenue projections disguised as add-backs. "We could easily grow revenue 20% with better marketing" is not an add-back. It's a projection, and lenders won't give it credit in the DSCR calculation.
• Undocumented "cash income." If the owner claims they take cash out of the register that isn't on the books, the lender can't use it. Undocumented income is invisible to underwriting.
• Eliminating essential expenses. Adding back the marketing budget and claiming the new owner won't need to advertise is not credible.

Here's my rule of thumb: if you can't defend the add-back to a skeptical credit officer with documentation, don't include it. Every aggressive add-back you put in the package reduces your credibility on the add-backs that are legitimate. Lenders remember who sends them inflated packages.

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Personal Financial Statement Analysis

The PFS — SBA Form 413 — is the borrower's personal balance sheet. It lists all personal assets, all personal liabilities, and calculates net worth. Every individual who owns 20% or more of the borrowing entity must submit one.

What you're looking for:

Net worth. Assets minus liabilities. A positive net worth is expected. A negative net worth doesn't automatically kill the deal, but it raises serious questions about the borrower's financial capacity and discipline.

Liquidity. How much of the borrower's net worth is liquid — cash, marketable securities, retirement accounts? A borrower with a $2 million net worth concentrated entirely in real estate equity has a very different risk profile than one with $500,000 in liquid savings. Liquid assets support the equity injection and provide a cushion for post-closing operating needs.

Contingent liabilities. Guarantees on other loans, pending lawsuits, potential tax liabilities. These are often buried in the notes section and can materially change the financial picture if they materialize.

Lifestyle burn rate. This one doesn't appear on the PFS directly, but you can infer it. If the borrower has $150,000 in personal debt, a $4,000 monthly mortgage, two car payments, and private school tuition, their personal cash flow obligations are substantial. That matters because the borrower is personally guaranteeing the SBA loan, and a lender wants to know the borrower isn't already stretched thin.

I always tell originators: read the PFS like a credit officer. Don't just check that it's filled out. Actually look at the numbers and ask yourself whether this person has the financial foundation to take on a business loan. If your gut says it's thin, the credit officer's gut will too.

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DSCR Calculation Walkthrough

The debt service coverage ratio is the single most important number in SBA underwriting. If you don't know how to calculate it, you cannot evaluate deals. Period.

Here's the formula:

DSCR = Adjusted Net Operating Income / Total Annual Debt Service

Most lenders want to see a minimum DSCR of 1.15x to 1.25x. That means the business generates 15% to 25% more cash flow than it needs to cover all debt payments. Below 1.15x, you're in trouble. Below 1.0x, the deal is dead — the business literally doesn't make enough money to pay its debts.

Step-by-step example:

A borrower wants to buy a business for $500,000. The SBA loan is $450,000 (10% equity injection = $50,000 down). The loan term is 10 years at 10.25%.

1. Start with net income from the P&L: $120,000
2. Add back depreciation: $15,000
3. Add back owner's excess compensation: $40,000 (owner paid $140,000; replacement manager costs $100,000)
4. Add back interest on debt being refinanced: $8,000
5. Subtract a reasonable new owner salary: -$100,000 (if different from what was added back)
6. Adjusted Net Operating Income = $83,000

Wait — that doesn't look right. Let me recalculate the way lenders actually do this:

1. Net income: $120,000
2. + Depreciation: $15,000
3. + Interest: $8,000
4. + Owner excess comp (above market): $40,000
5. = Adjusted cash flow (seller's discretionary earnings): $183,000
6. - New owner's salary at market rate: $100,000
7. = Cash available for debt service: $83,000

Now, what's the annual debt service?

$450,000 loan at 10.25% over 10 years = approximately $72,000 per year ($6,000/month).

DSCR = $83,000 / $72,000 = 1.15x

That's right at the floor. Some lenders will approve it. Others want 1.20x or higher. An experienced originator looks at this and says: this deal is tight but workable. If we can get the seller to carry a note on standby, or if the buyer has additional income sources, or if the actual cash flow is slightly higher than the tax returns show (because of conservative add-backs), we have a path. If none of those things are true, we might be forcing a deal that doesn't work.

The DSCR is where deals live or die. Learn to calculate it quickly and accurately, and you'll know within minutes of seeing the financials whether a deal is worth pursuing.

For more on how DSCR fits into the broader valuation picture, see our article on What Is My Business Worth.

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Red Flags in Financial Statements

These are the patterns that should make you slow down and ask hard questions:

Declining revenue with stable or increasing expenses. The business is losing efficiency. Either demand is dropping or the owner has lost pricing power. Either way, the DSCR is heading in the wrong direction.

Accounts receivable growing faster than revenue. This means the business is selling but not collecting. It could indicate customer concentration risk, poor collections processes, or customers who are themselves in financial trouble.

Inventory buildup. If inventory is growing significantly faster than sales, the business may be sitting on obsolete stock or overordering. That inventory is worth less than what the balance sheet says.

Related-party transactions. The business is buying from or selling to entities owned by the same people. These transactions may not be at market rates, which distorts the financials. Lenders scrutinize these heavily.

Frequent changes in accounting methods or fiscal year. This can indicate the owner is manipulating reporting to paint different pictures for different audiences (banks vs. the IRS, for example).

Large "other income" or "other expense" line items. What's in there? If a significant portion of the business's income comes from a line item labeled "other," you need to know what it is and whether it's recurring. Same for expenses.

Tax returns don't match the P&L. If the borrower gives you a P&L showing $200,000 in net income but their tax return shows $90,000, somebody is telling two different stories. Lenders use the tax returns, not the internal P&L, as the source of truth. The disconnect needs to be explained and reconciled.

Personal expenses commingled with business. Some level of this is normal in small businesses. Excessive commingling — where you can't tell where the business ends and the owner's personal life begins — is a sign of poor financial management and makes the underwriting process a nightmare.

Every one of these red flags is something you should be catching at intake, before the package goes to a lender. An originator who can spot these issues early saves themselves time, saves the borrower frustration, and builds credibility with lenders who appreciate clean submissions. If the deal does get declined because of financial issues, our guide on what to do when your SBA loan gets denied covers the recovery playbook — including when to fix and resubmit versus when to find a different lender.

For more on what lenders look for in acquisition packages and how to address weaknesses before they become problems, check out our Complete Guide to SBA 7(a) Loans.

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Frequently Asked Questions

How many years of financial statements do SBA lenders require?

Most lenders want three years of business tax returns, three years of personal tax returns for all owners with 20%+ ownership, and a year-to-date interim P&L and balance sheet. Some will work with two years if the business is newer, but three is standard.

What if the borrower's business is a cash-heavy operation with unreported income?

If income isn't on the tax returns, it doesn't exist for underwriting purposes. Lenders base their analysis on documented, reported income. An originator should never encourage a borrower to claim undocumented cash income — it's not usable and it creates compliance risk.

Can a deal with a DSCR below 1.15x still get approved?

It depends on the lender and the compensating factors. Some lenders will go to 1.10x if the borrower has exceptional experience, significant personal liquidity, or strong collateral. Below 1.0x is essentially impossible. The business needs to demonstrate it can cover the debt.

What's the difference between EBITDA and seller's discretionary earnings?

EBITDA (earnings before interest, taxes, depreciation, and amortization) is the standard metric for larger businesses. Seller's discretionary earnings (SDE) adds back the owner's total compensation, making it the preferred metric for small, owner-operated businesses where the owner's salary is a significant portion of cash flow.

How do lenders handle businesses with large depreciation deductions?

Depreciation is a non-cash expense and is always added back for cash flow analysis. A business with $50,000 in net income and $80,000 in depreciation actually generated $130,000 in cash flow. Heavy depreciation is common in asset-intensive businesses (manufacturing, trucking, construction) and is well understood by SBA lenders.

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This article covers the fundamentals. In Module 4 of our training at learn.lordsoflending.com, we go deeper with tax return analysis frameworks, advanced add-back strategies, multi-entity financial consolidation, and live deal walkthroughs where we analyze real borrower financials and build the DSCR case from scratch.

Once you can read the financials, the next skill is structuring around what you find. Our article on the art of SBA deal structuring covers how to turn financial analysis into a deal narrative the credit committee can get behind.

The eight patterns that kill deals — even when the financials look clean — are documented in Why Most SBA Deals Fall Apart. Most of them are structural problems that surface after the financials are already reviewed.

For the equity vs. cash flow debate — and why the industry's focus has shifted — Episode 20: Why Equity (Not Cash Flow) Makes or Breaks SBA Deals features a 40-year SBA veteran who has processed over a thousand liquidation packages.

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This content is for educational purposes only and does not constitute legal, financial, or investment advice. Consult with a qualified attorney, CPA, and financial advisor before making business or financing decisions. Loan terms, rates, and programs are subject to change and vary by lender.