When a business applies for finance, the debt service coverage ratio (DSCR) measures how much cash is available each month to service the debt or cover debt obligations. This includes payments for leases, loans (principal payment and interest payments) and sinking funds.
How the debt service coverage ratio impacts business finance approval
As with any other type of loan, when business owners seek finance, lenders will carefully consider the financial position of the business before making a decision. That means calculating the ratio (debt service ratio) to see if the company has the ability to make loan repayments and other debt payments. This enables the lender to determine if the business owner can make repayments on time. Generally speaking, if your business generates enough income to cover operating expenses, lenders will be more confident in offering you finance.
Many banks and non-bank lenders look for a minimum DSCR to approve a business loan. In most cases, the magic number is at least 1.2 or higher. There could be exceptions in some instances; for example, a lender might accept a ratio as low as 1.1 if the economy as a whole appears to be performing well. If the economy isn’t as strong, they might want the financial ratio to be as high as 1.5. So if your debt service coverage ratio is high, you’ll have a much better chance of getting approval for the business loan. This is because a high ratio shows you have enough cash to cover your debt payments.
To calculate DSCR, you start with net operating income and the company’s total debts. It’s calculated by dividing these two amounts. Net operating income is the revenue that the company is generating after meeting operating expenses (this excludes interest payments and taxes). It’s called Earnings Before Interest and Taxes (EBIT).
The Debt Service Coverage Ratio formula
Net Operating Income (NOI) ÷ Total Debt Service
Net Operating Income (NOI) = Income or Revenue You Generate – Certain Operating Expenses (COE)
Total Debt Service = Existing Debt Obligations
Consider the XYZ Company
Here’s another example of how to crunch your DSCR formula. Suppose the XYZ Company has Net Operating Income (NOI) of $400,000. It is seeking a loan and the debt service is going to cost them $280,000 over 12 months.
$400,000 ÷ $280,000 = 1.42
Using the formula, the debt service coverage ratio (DSCR) is 1.42.
But what if the company already has a debt service of $70,000 annually? The lender will add that amount to $280,000 to get a total debt service amount of $350,000.
$400,000 ÷ $350,000 = 1.14
So the DSCV is going to drop down to 1.14.
DSCR as easy as ABC... for your company
After seeing the good it has done for XYZ in getting a business loan sorted, the ABC Company now wants to figure out its DSCR too. Easy-peasy. This particular company has an NOI of $250,000, and the debt service amount is $230,000. So the ratio is 1.08 when you divide the NOI by the total debt service.
If the ratio falls because the company has too many loans and their NOI is not sufficient, getting a loan from a bank or a lender might not be that easy. Some lenders may offer finance even when the ratio doesn’t look too crash hot. But, as a business owner, you then need to think whether it’s really worth it – you don’t want to get into a position where you can’t make your loan repayments.
A business loan is suitable when it helps you generate income and improve your financial situation. So it’s important to understand your present situation and how the funds are going to assist your business before taking out a business loan. If you’re seeking business finance, calculating your DSCR will show you how you appear in the eyes of potential lenders.
Boosting your debt service coverage ratio
Ratios will naturally move up and down, depending on your income, expenses and obligations. That said, if your DSCR is low, here are a few proactive steps you can take to increase the ratio:
- Analyse your operating expenses and do everything possible to cut down on unnecessary expenses.
- Eliminate potential waste to increase the efficiency of your business.
- Pay off existing debts to increase the ratio.
- Consider a lower loan amount to increase your DSCR.
Other financial ratios and formulas to analyse your business
If you’re interested in this topic, there are many other formulas and ratios you can use to analyse and benchmark your business. Check out: