Debt Service Coverage Ratio / Debt Service CoverageWhen you submit a loan application, your lender’s number one question will be, “will this company be able to pay the loan back – or not?”
Lenders want to protect their investments, and as a result, they seek reassurance that the business they’re lending to is sound; that it has generated—and will continue to generate—enough income to pay back the loan with interest.
Smart business owners know that proving credit worthiness to lenders comes in many forms, including financial formulas and calculations. While it can seem like there are a phone book of numbers and financials to learn about, some are more important than others.
One number in particular represents the key to the kingdom in terms of accessing financing for a small business. That number, which every small business owner should understand, is the the debt-service coverage ratio (DSCR)—also known as the debt coverage ratio (DCR). This is the amount of cash a business has available for paying off its debt.
Why Your DSCR Is Crucial in Obtaining a Loan
In addition to your ability to repay funds and generate revenue, lenders also want to see that you have some “cushion” on hand in case of an unexpected expense. For example, if you barely generate enough revenue to cover the debt service (principal and interest, current leases, plus anything else you owe), your business is not likely to qualify for a loan.
The DSCR measures the degree of cushion you have available in your cash-flow, which equates to exactly how prepared your business is to make it through a rainy day and still make loan payments on time.
Calculating Your DSCR
While different lenders may use slightly different formulas to calculate your DSCR, there are two most common equations that you can use to see in advance what your lenders will see:
Annual Net Operating Income + Depreciation & Other Non-Cash Charges
Interest + Current Maturities of Long-Term Debt
Or
EBITDA (Earnings Before Interest, Taxes, Depreciation & Amortization)
Interest + Current Maturities of Long-Term Debt
From these calculations, take the figure to the second decimal point. For example, if an ergonomic office chair maker has a total annual net operating income is $40,000 and they are applying for a loan whose debt service will cost $32,000 annually, their debt service coverage ratio is 1.25 ($40,000/$32,000).
The Higher, The Better
Every lender has a minimum debt-service coverage ratio requirement for approving a business loan. In general, this needs to be 1.25 or more. In some cases, when the economy is buoyant, lenders might accept a ratio as low as 1.15. However, when the economy is tight, they may require a ratio of 1.35 or even 1.5. The higher your ratio—or the more of a cash cushion you have above the minimum requirements— the better your chances of getting a business loan in any economy.
Before approaching a lender for a business loan, you need to calculate your DSCR and, if it’s not quite up to par, take steps to improve it. The financial projections in the business plan you present to prospective lenders should include your DSCR 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 DSCRs for the past three years. Lenders want future projections, as well as proven evidence that your business is thriving.
Current Debt is a Factor
Keep in mind that the lender will also consider any current debt service you have in addition to the new loan amount, so you need to include that in your calculation. In the above scenario, if the office chair company already had $8,000 in debt service from a loan on a hydraulic part, taking on an additional $32,000 in debt service would bring their total debt service to $40,000. In this scenario, the DSCR would drop to 1.0—generally not high enough to obtain a loan.
Whether or not you are applying for a small business loan, maintaining a good DSCR is important.
Taking your business to the next level means being aware of all aspects of your operations: finance, product and marketing. As an owner, taking the reigns on finance and lending knowledge will help you make the best decisions for the financial health of your company.
