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.
Debt service coverage ratio 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.
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. A ratio over 1 is good, and the higher the better.
Lenders 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.
Having just enough cash to cover your loan payments generally isn’t enough. Lenders don’t want to see you just scraping by. They want to see that you have a sufficient cash “cushion”—cash flow above and beyond the minimum—to pay off the loan. If you have barely enough cash coming in to cover your debt payments, your business is probably not doing well enough to warrant a loan.
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.
Debt Coverage Service Ratio Formula and Example
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
Let’s break down the formula with an example.
DSCR Formula Example
The first step in calculating 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 with 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: 2 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.
Some Lenders Use a Global DSCR
As you might have already learned in your business loan search, personal finances can have a big impact on your approval for a small business loan. Some lenders 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.
All in, though, the standard formula for DSCR is the business’s annual net operating income (EBITDA) divided by the business’s annual debt payments.
Common Mistakes When Calculating DSCR
The formula for DSCR is simple enough, but as you can see from the example above, the calculations are pretty detailed. There’s room for error, so regularly talk with the lender during the underwriting process, and provide all financial statements that the lender asks for.
When trying to figure out your own ratio, there are a couple common mistakes that can trip you up.
DSCR Mistake #1: Not Accounting for Existing Business Debt
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.
In the example above, if the business owner already had a business loan with annual payments of $20,000, we would need to add that into the calculation. In that case, the annual debt payments would increase to $142,148, and the DSCR would decrease to 1.55.
DSCR Mistake #1: Not Accounting for All Types of Business Debt
Another common mistake is forgetting to include all types of business debt when calculating your total debt service.
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.
What Debt Service Coverage Ratio Do You Need to Qualify for Financing?
While every lender is different, most that assess DSCR look for a ratio of 1.15 or more. In some cases—when the economy is doing great—they might accept a ratio as low as 1.10, but in others—when the economy is tight—they may require a ratio of 1.35 or even 1.5.
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 exact DSCR a lender will look for depends on their business loan requirements. Sometimes, you can compensate for a lower ratio if other aspects of your loan application are strong. For example, having lots of collateral or a high credit score might make up for a low DSCR. But, the higher your ratio, the better your chances of getting a business loan in any economy and with any lender.
As part of your business loan application, you’ll have to submit financial statements and possibly a business plan. The financial projections in the business plan should include the debt service coverage ratio for the next three years. In addition, if you have a growing business or are seeking a loan to buy an existing business, the lender will want to see debt service coverage ratios for the past three years. That way, they’re not just relying on predictions, but can see evidence that your business was thriving and will be in the future.
Do All Lenders Check DSCR?
Debt service coverage ratio isn’t part of every lender’s underwriting process, but is pretty common:
- The SBA requires borrowers to have a DSCR over 1.15 for SBA 7(a) loans over $350,000.
- Banks usually check DSCR for traditional (non-SBA) loans.
- Online medium-term lenders typically check DSCR.
Brian Cairns, CEO of ProStrategix Consulting, says, “We’ve seen DSCR used most often for larger loans, over $100K or more. For smaller loans, we’ve seen greater reliance on personal credit ratings, credit utilization, and collateral. The banks may use it in both cases, but it is less explicit at the lower end of business loans.”
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.
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 a couple steps you can take to improve your DSCR.
One way is to increase your business’s revenues. Can you negotiate higher pay on a contract? Can you increase the price of your product or service? The other way to improve your ratio is to lower your business’s operating expenses. Take a look through your latest profit and loss statement or speak with your accountant about cost cutting measures. Can you negotiate a lower rent on office space with your landlord? Can you cut back on some staffing? Can you 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.
“In a business with stable gross margins like ours,” says Hacshka, “You can really improve the DSCR by looking … for cost saving opportunities. 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. If you come and say, ‘I can operate this business will two fewer people in a smaller facility at a lower rent price, or I’m going to save 10% on my purchases by renegotiating these contracts,’ etc., the lender may give you financial credit for those changes by adjusting the net income for the new plan.”
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.
Improving your ratio is as simple as lowering your business’s operating expenses or increasing your revenues. Take a look at your financial statements or talk to your accountant for help.
Debt Service Coverage Ratio: An Important Number On Your Business Loan Application
Debt service coverage ratio (DSCR) is an important metric lenders use to determine your business’s ability to pay back a loan.
Follow these tips to calculate and improve your DSCR:
- DSCR is the business’s annual net operating income divided by the business’s annual debt payments. In most cases, lenders use EBITDA as net operating income.
- Most lenders expect a ratio of 1.15 or higher, but requirements vary among lenders.
- Check with your lender on how they calculate DSCR. Some lenders use global DSCR and take into account personal income and debt.
- Make sure you include all types of debt and existing debt when calculating your DSCR.
- If your ratio is too low, think about cost-cutting and profit-boosting measures
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!