When you apply for a loan, lenders want to make sure your small business can repay it. One way lenders determine this is by calculating our debt service coverage ratio (DSCR). This is also referred to as the debt service ratio or debt coverage ratio. Your debt service coverage ratio is calculated by dividing your business’s net operating income by your annual debt payments. We will talk you through how to calculate it for your small business and how the ratio affects your ability to qualify for a loan.
What Is Debt Service Coverage Ratio?
Debt service coverage ratio is a measurement of the cash flow available to pay current debt obligations. It states income as a multiple of debt obligations due within the year. In order to calculate it, you need to have accurate information about your business finances.
The first step to calculate DSCR is to determine the annual net operating income (NOI). Your NOI is subtracting your business expenses from your earnings. This information can be found in your profit and loss statements. Operating expenses do not need to include taxes, interest payments, depreciation, and amortization. Your business expenses are your cost of goods sold which include rent, labor, transportation, materials, and more.
The second step is to determine your annual debt obligations. This includes any existing loans you are repaying. Your DSCR is based on annual figures and your annual debt obligations will change based on when your loan term starts.
Next, you are ready to calculate your DSCR which is your annual net operating income divided by your annual debt obligation.
What is a Good Debt Service Coverage Ratio?
The calculation net operating income divided by your annual debt obligation will provide you with your DSCR ratio. If you have a DSCR ratio of less than one, it means that you do not have the ability to pay your debts in full. For example, a DSCR of .96 means you are only able to pay 96% of your debt obligations meaning you should not be borrowing more money.
A DSCR of one says that 100% of your net income goes towards paying your debt. This leaves you vulnerable to fluctuations in your cash flow.
A DSCR that is greater than one means your business has enough income coming in that it can pay its debts. For example, a DSCR of 1.30 means you are making 30% more income than you need to cover your debts.
Lenders have different requirements about what a good DSCR means. It depends on external factors such as the health of the economy. However, a debt coverage ratio of 1.15-1.35 is considered good in most circumstances.
How to Improve Your Debt Service Coverage Ratio
If your ratio is not where you would like it to be, you can increase your debt coverage ratio in a few ways.
- Decrease borrowing amount
- Decrease your operating expenses
- Reduce your existing debt
- Increase your net operating income
Take some time to improve your DSCR because it will help you beyond applying for a business loan. Depending on your loan agreement you will maintain an adequate debt service coverage ratio while you are paying off a loan.
Be sure to regularly monitor your debt service coverage ratio to make sure that it does not decline.
The Bottom Line
The debt service coverage ratio plays a huge factor in lending decisions when you are searching for funding. Lenders will use your ratio to determine whether you can afford to repay the loan or not and how much you can borrow. It is also helpful for understanding the financial health and cash flow of your business. If your DSCR is not where you would like to be, being to improve it before applying for financing.