What Is Debt Service Coverage Ratio?
The debt service coverage ratio (DSCR) compares a business’s level of cash flow to its debt obligations, calculated by dividing the business’s annual net operating income by the business’s annual debt payments. A DSCR that’s greater than one indicates that the business has enough income to comfortably cover loan principal and interest payments.
When you apply for business loans, lenders use a variety of quantitative and qualitative metrics to assess your eligibility. Among these metrics, DSCR is one of the most important because it goes to the heart of the question that every lender tries to answer: Can you pay back this loan on time and in full?
Your business’s DSCR helps the lender determine whether or not your business can take on the small business loan, how large a loan to approve, and what terms you’ll get on the financing.
Calculating DSCR isn’t as simple as plugging some numbers into a formula. You need to understand how to interpret your result, what goes into the calculation, and which lenders check DSCR. Learn about all of this, plus how to improve your DSCR if your ratio isn’t high enough to qualify for the best financing. Start with this video to understand why this metric is important.
Debt Coverage Service Ratio Formula
Lenders can have slightly different ways of calculating DSCR. Early on in your loan application process, ask your lender whether they check DSCR and how they calculate this ratio. That said, if you want to calculate this number for yourself, this is the most common formula for calculating debt service coverage ratio (DSCR):
Debt Service Coverage Ratio (DSCR) = Business’s Annual Net Operating Income / Business’s Annual Debt Payments
The DSCR formula must include existing debt as well as the loan you’re applying for. A common mistake that business owners make when calculating their debt service coverage ratio is only accounting for the loan that they’re applying for. Lenders need to see how all your business debt, including any business debt that you already have, will affect your ability to pay back the loan.
All of the following are types of debt that you should include in your DSCR formula:
- Bank loans and online loans
- Short-term loans
- Leases (such as equipment leases)
- Invoice financing
- Business lines of credit and business credit cards (you can estimate your monthly payments to calculate debt service on a credit card or line of credit)
All types of debt can cut into your cash flow and impact your ability to pay back a loan, so be prepared to include all debt in your DSCR calculation. Lenders want a full picture of your debt service, so you’ll also need to notify them of credit cards, leases, lines of credit, and other types of debt you already have.
How to Calculate DSCR: Example
The first step in calculating the debt service coverage ratio is to figure out your annual net operating income. Most lenders use EBITDA (earnings before interest, taxes, depreciation, and amortization) as the equivalent of net operating income in the DSCR formula.
To get EBITDA, take your business’s annual net income (revenues minus all expenses) and add back in taxes, interest, depreciation, and amortization. Adding these expenses back into your earnings standardizes DSCR across different types of businesses and industries.
Step 1: Calculate Annual Net Operating Income/EBITDA
Annual Revenues: $500,000
- Rent: $60,000
- Payroll: $100,000
- Marketing: $30,000
- Inventory: $30,000
- Taxes: $120,000
- Interest Payments: $40,000
- Depreciation: $20,000
- Amortization: $10,000
= Annual Net Income (to get this, subtract above expenses from revenue) = $90,000
- Taxes: $120,000
- Interest Payments: $40,000
- Depreciation: $20,000
- Amortization: $10,000
= Annual Net Operating Income/EBITDA (add back above expenses) = $280,000
Step 2: Calculate Annual Debt Payments (include existing loans and loans you’re applying for)
- Business Loan Amount: $200,000
- Annual Interest Rate: 20%
- Term: two years
= Annual Debt Payment (including interest): $122,148
Step 3: Divide Annual Net Operating Income by Annual Debt Payments to Get DSCR
DSCR = 280,000 / 122,148 = 2.3
In this example, the business has a ratio of 2.3, which is excellent. This means the business has 230% more incoming cash flow than needed to cover debt payments each year.
Note that it’s possible to calculate DSCR on a monthly basis instead of an annual basis. If your business is less than one year old, or if you’re applying for a short-term loan, calculate DSCR on a monthly basis for a more accurate result. In this case, the instructions are the same, but you would simply divide the monthly EBITDA by the monthly debt payments.
Why Debt Service Coverage Ratio (DSCR) Is Important
Debt service coverage ratio (DSCR) is one of many financial ratios that lenders assess when considering a loan application. This ratio is especially important because the result gives some indication to the lender of whether you’ll be able to pay back the loan with interest. While every lender is different, most that assess DSCR look for a ratio of 1.15 or more.
Here’s how to interpret your DSCR:
- DSCR < 1: You have negative cash flow. You don’t have enough income to service all of your debt.
- DSCR = 1: You have exactly enough cash coming in to service your debt, but you don’t have an additional cash cushion.
- DSCR > 1: You have positive cash flow. The higher your DSCR, the more income you have to pay off your debt.
The larger the loan you’re applying for, and the longer the term, the more emphasis lenders will put on DSCR. Short-term lenders get their money back more quickly, so they tend to rely more on credit history and monthly revenues than on DSCR. They don’t want to lose their investments or take the trouble of chasing down a borrower who defaults. So, they look for reassurance that your business has generated—and will continue to generate—enough income to pay back the loan with interest.
Without a strong cash cushion, your business is vulnerable. For example, if sales slow down or a big client parts ways with your company, then you might fall behind on loan payments. The DSCR gives lenders a look into your company’s cash flow and how much extra cash you have on hand to cover your loan payments and run your business comfortably, too. Some lenders even use a global debt service coverage ratio (DSCR), which accounts for personal sources of income and personal debt in addition to business income and debt.
Global DSCR has a larger scope than the standard DSCR formula. For example, if you have personal investment income or a day job, the lender will consider those income streams when calculating net income. Likewise, they’ll consider home loans, car loans, student loans, and other personal loans as part of your total debt service. For global DSCR, the lender might even consider income and debt from your business partners and loan guarantors.
If you’ve managed your personal finances very well, then accounting for personal income streams might boost your ratio and help you qualify for the loan. But, if you have a lot of personal debt, then global DSCR might hurt your chances of qualifying for the loan.
How to Improve Your Debt Service Coverage Ratio
If your debt service coverage ratio is keeping you from qualifying for a business loan, don’t worry. There are two ways you can improve your DSCR:
- Increase your business’s revenues: Finding ways to increase revenue can boost your DSCR. Try negotiating higher pay on a contract, or increasing the price of your product or service.
- Lower your business’s operating expenses: Another way to improve your DSCR is to look through your latest profit and loss statement or speak with your accountant about cost-cutting measures. Negotiate a lower rent on office space with your landlord, cut back on staffing, or tighten your marketing budget.
Even if your ratio is low at the moment, you might be able to convince the lender that you’re going to improve it in the future by cutting back on expenses or increasing revenues. This helped Nick Haschka, owner of office plant service business The Wright Gardner, qualify for a business loan.
“You can really improve the DSCR by looking… for cost saving opportunities,” says Hacshka. “In our case, we made a few small staffing adjustments in the go-forward operating plan that we submitted to the lender to account for changes that had just happened but were not reflected in the historical financials.”
Taking some time to improve your DSCR is worth it because this ratio will go beyond your initial business loan application. Depending on your loan agreement, you’ll have to maintain an adequate debt service coverage ratio while you’re in the process of paying off a loan.
Lenders might periodically measure your debt service coverage ratio. To ensure your debt service coverage ratio doesn’t decline, causing you to violate your loan agreement, you should monitor your business’s finances on a monthly or quarterly basis.
The Bottom Line
Debt service coverage ratio (DSCR) is an important metric lenders use to determine your business’s ability to pay back a loan. By improving your ratio, not only will you increase your chances of qualifying for a loan, but you will also better the health of your business’s overall finances. And that’s always a good thing.
The post Debt Service Coverage Ratio: How to Calculate DSCR appeared first on Fundera Ledger.