Module 4: Debt Amortization Schedules & The Debt Service Coverage Ratio (DSCR) Waterfall

Learning objectives and prerequisites

By the end of this lesson, you should be able to construct all monthly payments and named coverage tests. Prerequisite knowledge: Annuities, income taxes and cash flow. Work from assumptions to equations, explain the acquisition consequence, and record the evidence needed to rely on the answer.

Debt capacity is a dated cash-flow question

A buyer who knows the loan's interest rate still does not know its payment. Principal, maturity, amortization frequency, reset convention, and fees determine the actual obligation. A lender then compares required service with a defined earnings or cash-flow measure. Using the wrong payment or numerator can make an unaffordable acquisition appear comfortable.

This chapter builds Precision Valve & Actuator's senior schedule from first principles. The loan is $4 million, amortizes over 120 months, and initially charges 10% nominal annual interest. For the base projection, the rate remains unchanged; this is a constant-rate scenario for a variable-rate loan, not a claim that Prime cannot move. All figures are actual US dollars.

The analysis uses two separate coverage measures. The current SBA acquisition framework's historical EBITDA-based DSC is distinguished from the buyer's cash-flow-based DSCR. Precision's assumed lender also imposes a 1.25x buyer-CFADS covenant for teaching purposes. That covenant is an explicit case term, not a claim that every SBA lender defines its covenant this way.

Derive the payment rather than memorize an annual factor

If monthly interest is i, the outstanding balance grows by i before each payment reduces it. A fixed payment A repays principal P over n periods when the present value of all payments equals the principal. Solving that annuity relationship gives the familiar amortization equation.

i = nominal annual rate / 12
n = years × 12
Payment A = P × i / [1 − (1 + i)^(-n)]
Interest_m = beginning balance_m × i
Principal_m = payment_m − interest_m
Ending balance_m = beginning balance_m − principal_m

For Precision, i is 0.10 / 12 and n is 120. The payment is $52,860.2947527 before display rounding. Annual scheduled service is twelve payments, or $634,323.537032. Keep full precision in calculations and round only displayed numbers unless the actual note specifies cent-level payment mechanics.

A zero-rate loan requires a separate case: payment equals principal divided by periods. In a spreadsheet, =-PMT(rate/12,120,principal) gives a positive payment under the usual Excel sign convention. The sign is not a substantive financing assumption; it reflects how the function distinguishes money advanced from money returned.

Follow the first payments dollar by dollar

Month 1 interest is $4,000,000 × 10% / 12 = $33,333.33. Subtracting it from the $52,860.29 payment leaves $19,526.96 principal. Closing debt is therefore $3,980,473.04. Month 2 interest applies to that lower balance, not to the original $4 million.

The payment stays level while interest gradually falls and principal rises. Early debt repayment is slow because a large opening balance produces substantial interest. A buyer who assumes the loan repays one-tenth of original principal each year will overstate early deleveraging and understate interest.

Month	Opening debt	Cash payment	Interest	Principal	Ending debt
1	$4,000,000.00	$52,860.29	$33,333.33	$19,526.96	$3,980,473.04
2	$3,980,473.04	$52,860.29	$33,170.61	$19,689.69	$3,960,783.35
3	$3,960,783.35	$52,860.29	$33,006.53	$19,853.77	$3,940,929.59
12	$3,776,026.05	$52,860.29	$31,466.88	$21,393.41	$3,754,632.64
60	$2,519,751.64	$52,860.29	$20,997.93	$31,862.36	$2,487,889.28
120	$52,423.43	$52,860.29	$436.86	$52,423.43	$0.00

The final scheduled payment is adjusted to the exact remaining principal plus interest if necessary. A model should cap principal repayment at the outstanding amount rather than let debt become negative. Cumulative principal over the full schedule must equal $4 million, and ending debt at month 120 should be zero within a documented numerical tolerance.

Monthly versus annual amortization

An annual loan with ten equal year-end payments at 10% has payment about $650,981.58. That is not the same contract as twelve monthly payments totaling $634,323.54 each year. Monthly principal begins reducing the interest-bearing balance before year-end, changing both timing and total interest.

For a monthly note, do not calculate a year-end annuity and divide it by twelve. Use monthly periods from the start, then aggregate the actual monthly rows. Annual interest is the sum of monthly interest, not simply original principal multiplied by the annual rate every year.

Year	Opening debt	Annual service	Interest	Principal	Ending debt
1	$4,000,000.00	$634,323.54	$388,956.17	$245,367.36	$3,754,632.64
2	$3,754,632.64	$634,323.54	$363,263.00	$271,060.53	$3,483,572.10
3	$3,483,572.10	$634,323.54	$334,879.42	$299,444.11	$3,184,127.99
4	$3,184,127.99	$634,323.54	$303,523.71	$330,799.82	$2,853,328.17
5	$2,853,328.17	$634,323.54	$268,884.65	$365,438.89	$2,487,889.28
6	$2,487,889.28	$634,323.54	$230,618.42	$403,705.12	$2,084,184.16
7	$2,084,184.16	$634,323.54	$188,345.22	$445,978.32	$1,638,205.85
8	$1,638,205.85	$634,323.54	$141,645.46	$492,678.07	$1,145,527.77
9	$1,145,527.77	$634,323.54	$90,055.63	$544,267.91	$601,259.87
10	$601,259.87	$634,323.54	$33,063.67	$601,259.87	$0.00

A useful balance formula is original principal compounded through the elapsed months minus the accumulated value of payments. It can independently verify the row-by-row schedule. At month 60, Precision's remaining principal is approximately $2,487,889.28, not $2 million. Early payoff at that point must settle the actual balance, together with any applicable contract charges.

Variable-rate resets and remaining maturity

Suppose the rate rises to 12% immediately after payment 12. Debt is then $3,754,632.64 and 108 months remain. Reamortizing that balance at 12% gives a monthly payment of approximately $57,011.22, or $684,134.58 annually. Reusing the original 120-month term would improperly extend repayment.

If only the spread increased from 2.75% to 3.00% while the assumed Prime remained 7.25%, the new rate would be 10.25%. At the same month-12 reset point, the remaining-term payment would be about $53,369.92 monthly. The note's actual reset and payment provisions control; this calculation assumes immediate reamortization.

The current SBA acquisition SOP, Appendix 15, requires a fully amortizing senior acquisition structure without a balloon. A model that holds payments fixed after a large rate increase must inspect whether the remaining term still repays the balance. It cannot solve the problem by hiding residual principal at maturity.

The cash-flow waterfall begins with operating economics

Precision earns $8 million revenue. Variable operating costs are 55% of revenue, or $4.4 million, and recurring fixed operating costs are $2.2 million. EBITDA is therefore $1.4 million. Fixed costs include required replacement management, market occupancy costs, insurance, and ordinary maintenance expense. These costs do not automatically fall when sales decline.

Book D&A is $200,000. For the prospective model, assume fully deductible cash interest and a hypothetical cash tax of 25% of positive taxable income. Negative taxable income produces zero current cash tax, not an immediate refund. Maintenance CapEx is $200,000 and additional annual cash NWC investment is $50,000. These assumptions simplify actual tax and working-capital behavior.

Year 1 interest from the monthly schedule is $388,956.17. Pretax income is $1,400,000 − $200,000 − $388,956.17 = $811,043.83. Cash taxes are $202,760.96. The buyer's CFADS is therefore $1,400,000 − $202,760.96 − $200,000 − $50,000 = $947,239.04.

Normalized EBITDA                         1,400,000.00
Less cash income taxes                     (202,760.96)
Less maintenance CapEx                     (200,000.00)
Less incremental annual cash NWC            (50,000.00)
Buyer CFADS                                  947,239.04
Less senior interest and principal          (634,323.54)
Less current full-standby seller service              0
Residual cash retained                       312,915.51

Cash interest appears in the denominator as debt service, while its tax deduction affects the numerator through cash taxes. Do not subtract interest from CFADS again. Likewise, principal is not an income-statement expense, and the $100,000 NWC funded at closing is not repeated in this annual $50,000 investment.

Reconcile the waterfall to operating cash flow

Net income is $811,043.83 less $202,760.96 tax, or $608,282.87. Add $200,000 noncash D&A and subtract $50,000 NWC investment to obtain operating cash flow of $758,282.87. This figure already reflects cash interest through net income.

Subtracting $200,000 CapEx and $245,367.36 principal leaves the same $312,915.51 residual cash as the CFADS waterfall. The two approaches agree because one starts before debt service and the other begins after interest. Mixing the starting point from one with deductions from the other creates duplicated financing costs.

The interest tax shield is $388,956.17 × 25% = $97,239.04 under the case's usable-deduction assumption. Unlevered taxes would be $300,000 on $1.2 million EBIT. Actual modeled taxes are lower by that shield. It is already included in the cash calculation and must not be added again as a separate receipt.

Which DSCR is being measured?

The current acquisition appendix describes historical DSC using EBITDA and combined post-transaction debt service, with justified adjustments handled under its requirements. Initial Acquisition's relevant floor is 1.25x. Precision's accepted $1.4 million historical EBITDA divided by $634,323.54 service equals approximately 2.2071x.

Buyer CFADS divided by service equals 1.4933x. The case's separate lender covenant requires this more conservative measure to remain at least 1.25x. Its headroom is $947,239.04 minus 1.25 × $634,323.54, or about $154,334.62 of CFADS. Headroom to a 1.0x cash deficit is larger, but covenant breach can occur well before cash service becomes impossible.

Never say merely “DSCR is 1.49” without naming the numerator, denominator, period, and treatment of other debt. A seller interest-only note may require a more demanding underwriting amortization under the current appendix than its near-term contractual cash payment suggests. Full standby is not a universal excuse to ignore future principal at exit.

Revenue stress: costs do not all disappear with sales

Hold variable costs at 55% of stressed revenue and fixed costs at $2.2 million. Revenue declines of 10%, 20%, and 30% reduce EBITDA by 45% of the lost revenue. Hold the senior schedule, D&A, maintenance CapEx, and annual cash NWC requirement unchanged for this isolated stress. Holding NWC investment constant is deliberately conservative; a separate case can test releases or collection deterioration.

Revenue decline	Revenue	EBITDA	Cash taxes	Buyer CFADS	CFADS DSCR	Cash after service
0%	$8,000,000.00	$1,400,000.00	$202,760.96	$947,239.04	1.4933x	$312,915.51
10%	$7,200,000.00	$1,040,000.00	$112,760.96	$677,239.04	1.0677x	$42,915.51
20%	$6,400,000.00	$680,000.00	$22,760.96	$407,239.04	0.6420x	$-227,084.49
30%	$5,600,000.00	$320,000.00	$0.00	$70,000.00	0.1104x	$-564,323.54

The −10% case still pays debt from the defined cash flow, leaving $42,915.51, but breaches the assumed 1.25x CFADS covenant. The −20% case leaves a $227,084.49 annual cash deficit. At −30%, taxes reach the zero floor, so tax savings stop cushioning further earnings losses. Linear extrapolation beyond that point would overstate protection.

The EBITDA-based eligibility-style ratios are different: approximately 2.2071x, 1.6395x, 1.0720x, and 0.5045x across those scenarios. A projection stress does not retroactively replace the required historical underwriting test. It demonstrates prospective resilience and the likely consequences if performance changes.

Solve the exact breakpoints

While pretax income remains positive, EBITDA E produces CFADS of 0.75E − $200,000 + 0.25I, where I is Year 1 interest. The $200,000 constant combines the D&A tax effect with CapEx and NWC assumptions. Required service S is $634,323.537032.

Revenue loss fraction = d
EBITDA(d) = 1,400,000 − 3,600,000d
CFADS(d) = 947,239.043417 − 2,700,000d
For target coverage k:
    d = [947,239.043417 − k × 634,323.537032] / 2,700,000

Buyer CFADS coverage equals 1.25x at a 5.7161% revenue decline, with revenue about $7,542,712. It equals 1.15x at 8.0654%, and 1.0x at 11.5895%. All three points remain in the positive-tax region, so the equation is valid there. Immediately beyond each point the corresponding ratio is below the target.

For the EBITDA-based ratio, solve E = kS instead. Its 1.25x breakpoint is 16.8638% revenue decline and its 1.15x breakpoint is 18.6258%. These are not the same as the buyer-covenant breakpoints. Identifying both prevents a rigorous-looking stress test from making a false claim about which rule failed.

Liquidity can fail before an annual ratio does

Precision starts with $200,000 unrestricted cash. If collections are delayed by another $150,000 early in the year, that temporary need can consume most opening liquidity even while the full-year income statement remains unchanged. Inventory purchases and quarterly tax payments can make the trough worse than year-end cash suggests.

Build a monthly cash schedule or a 13-week forecast using dated collections, payroll, suppliers, taxes, investment, and monthly loan payments. An unapproved revolver is a financing gap, not cash available. Annual retained cash should not be distributed or swept away without verifying the next operating cycle and lender restrictions.

Lender Red Flags & SOP Violations: curing coverage with an unidentified draw.

Borrowing can fund a cash shortfall but does not improve operating CFADS. A draw creates new principal, interest, and possible eligibility constraints. Show the source, commitment, limit, cost, and repayment instead of using debt as a hidden cash plug.

Self-Study Problem Set

Problem 1: reproduce the first monthly row

Using $4 million principal, 10% nominal interest, 120 months, and the chapter payment, calculate Month 1 interest, principal, and ending debt.