Choose the Best Small Business Loan
In commercial and small business lending, debt service coverage ratio (DSCR) measures a business’s ability to cover its debt payments, such as loan payments or leases. In other contexts, such as corporate or personal finance, debt service coverage ratio has a different definition. Lenders frequently use debt service coverage ratio as one way to assess whether they should lend money to a business—so having a good debt service coverage ratio can be crucial to getting funds for your business.
Debt Service Coverage Ratio Terms
Debt service coverage ratio is a measure of a business’s ability to repay any loans or other debt obligations over the course of a year. Simply put, it shows how much cash a business has to cover its loan and other debt payments. It’s calculated by dividing a business’s net operating income by its total debt service.
Net operating income: Net operating income (NOI) is calculated as the difference between a business’s revenue/income and its operating expenses. It’s a measure of a business’s profit that includes all expenses except interest and income tax. Net operating income is typically calculated as:
Net Operating Income = Revenue - Operating Expenses
Net operating income may be calculated differently across lenders, so it’s important to understand which calculation your lender is using. For example, some lenders use EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortization) as net operating income.
Total debt service: Total debt service is the total annual payments that are made on any debt a business has, including loan repayments on principal and interest and lease payments. For example, if a business currently pays $15,000 per month on its debt obligations, then its total debt service would be $180,000 ($15,000 x 12).
How to Calculate Debt Service Coverage Ratio
As stated above, the debt service coverage ratio is calculated by dividing a business’s net operating income by its total debt service, and it’s frequently a number between 0 and 2.
Debt Service Coverage Ratio = Net Operating Income ÷ Total Debt Service
If a business’s debt service coverage ratio is 1.5, this means a business’s cash flow can cover 150% of its yearly loan payments. Similarly, if a business’s debt service coverage ratio is 0.8, this means that the business can only cover 80% of its yearly loan payments.
Let’s look at an example of a hypothetical business with the following income and expenses:
|Gross Income||Amount||Operating Expenses||Amount|
|Sales revenue||$250,000||Cost of goods sold||$100,000|
In the table above, this business has a gross income of $250,000 and operating expenses of $150,000. Its net operating income would be $100,000 ($250,000 - $150,000). Let’s also say this business has a total debt service of $70,000 per year across several loan payments. The business’s debt service coverage ratio would be 1.43 ($100,000 ÷ $70,000). If the business wanted to take out an additional loan with total annual payments of $30,000, then its total debt service would increase to $100,000 ($30,000 + $70,000) and its debt service coverage ratio would decrease to 1.00 ($100,000 ÷ $100,000).
What Does Debt Service Coverage Ratio Tell You
Lenders frequently want to see a business with a debt service coverage ratio of at least 1.2 to 1.5. Having a DSCR in this range means that a business will be able to repay on its debt obligations, even if the business experiences a drop in revenue. Businesses with a DSCR lower than this will have trouble getting approved for a loan. For instance, a business with a DSCR less than 1.0 wouldn’t even be able to cover its loan payments in full.
Another important factor when considering your business’s debt service coverage ratio is that lenders may have different thresholds for what is acceptable. Some lenders may only require 1.20, whereas another might require 1.45. Lenders may also want to see a business’s debt service coverage ratio from the past few years and projections for the next few years before approving a loan.
The DSCR threshold may also be stipulated in the loan contract, meaning that a business must stay at or above this threshold for the entirety of the loan term and the business will be required to recalculate its DSCR at the end of each fiscal year. When calculating your business’s DSCR, you should be following the same calculations as your lender. If a business’s DSCR falls below the threshold, the loan contract may be considered void.
When taking out a new loan, you should calculate your business’s debt service coverage ratio with all current debt obligations and the new loan before approaching your lender. If your business’s DSCR doesn’t meet the lender’s minimum requirement, you’ll need to take steps to fix this, such as paying off existing debt or cutting operating expenses. Once you have a loan, you should be monitoring your business’s DSCR regularly (quarterly or even monthly) to ensure it doesn’t fall below the lender’s minimum. Even if you aren’t taking out a loan, it’s still wise to monitor your DSCR in case you apply for a loan in the future.