What does DSCR (Debt Service Coverage Ratio) mean and how to calculate it?

When applying for a small business loan, numbers matter a lot. For example, the lender will want to know your income, your credit score, and your DSCR or Debt Service Coverage Ratio. Next we will explain what does DSCR mean and how to calculate it.

The DSCR (Debt Service Coverage Ratio) measures your company’s ability to pay off debt by dividing net operating income by total debt and interest payments. It is one of the main ways that lenders assess the financial health of your business before financing it.

When calculating the debt service coverage ratio or DSCR, the lender can find out how much cash a business has available to make principal, interest, and loan fee payments (They can also use it for lease payments.) You should find out your DSCR before approaching lenders so you can improve it if necessary.

Ideally, the DSCR should be 1.25 or more, but each lender will accept a different minimum DSCR.

what does debt service coverage ratio dscr mean

How to calculate your DSCR (Debt Service Coverage Ratio)

Below you will find the formula to calculate the DSCR and 3 steps to break down the formula:

Debt service coverage ratio =

Company’s Annual Net Operating Income / Current Year Debt Obligations.

  1. Calculate the annual net operating income of your business: Net operating income is business income less operating expenses, excluding taxes, interest payments, depreciation, and amortization (similar to EBITDA). These must be added back when calculating income, along with the owner’s salary and any one-time expenses that are not likely to recur.
  2. Calculate your business debt obligations for the current year: Add up the current year’s payments on the loan principal, loan interest, loan fees, and, if applicable, lease payments. Include payments on all business loans you currently have and the loan you’re applying for. If you are refinancing a loan, do not use the previous loan payment to calculate the DSCR; uses the new estimated payment.
  3. Divide the first figure (net operating income) by the second figure (current debt service): With this operation you will obtain the debt service coverage index.

Example: Let’s say you have a company whose annual net operating income is $100,000. After adding the principal, interest, and fees for the loan you’re applying for and any loans you already have, your business’s annual debt obligations are $40,000. The business has a DSCR of $100,000 / $40,000 = 2.50

If you already have an established business or are buying a business that is in operation, you must calculate its DSCR for the last three years. This is very important as it will give the lender an idea of ​​how the business has progressed over the past few years.

If you’re starting a new business that hasn’t started generating revenue yet, you should estimate your DSCR for the next three years and show those projections to lenders. Use industry averages and averages from similar companies to make your projections.

What DSCR do I need to qualify for a business loan?

All lenders have their own criteria for evaluating the DSCR or Debt Service Coverage Ratio, but in general, you will have a better chance of qualifying for a business loan if your DSCR is greater than 1.25. All things being equal, the higher your DSCR (above 1.25), the more likely you are to be approved for your loan and given better terms.

This will be the information that we can obtain through the DSCR of your business:

  • DSCR above 1: your company has enough income to pay its debts, and it has a “cushion” that it can use if there is any variation in the company’s cash flow. For example, a DSCR of 1.25 means that your business earns 25% more revenue than it needs to cover its debts.
  • DSCR equal to 1: All the net income of your company will go to the payment of debts. While this is better than having negative cash flow, your business is still vulnerable to even the slightest drop in earnings.
  • DSCR less than 1: your company does not generate enough income to pay its debts. For example, if your DSCR is 0.95, you have enough income to pay only 95% of your debts. To pay the rest, you would have to use personal sources of income, and this is not something a lender is comfortable with. A successful business should be able to support itself without recourse to personal income.

Remember that your lender may be willing to waive a slightly lower DSCR if other aspects of your application, such as business income and credit score, are very strong.

How can I improve the Debt Service Coverage Ratio (DSCR)?

If you need a higher DSCR to qualify for a business loan, you can increase your business income, reduce your business expenses, or decrease the amount of debt you owe. Taking all these actions at the same time will have a greater impact.

To increase the income of your business, you can try to sell more products or services or increase prices. Freshour suggests hiring a high-income, low-debt co-owner if the lender you’re working with considers personal income when calculating the DSCR. This can improve the company’s overall DSCR.

Another suggestion is to reduce the operating costs of your business. For example, you can ask your suppliers for better deals or postpone large capital expenditures unless absolutely necessary. Automating processes can also help reduce costs.

You should also focus on reducing your debt as much as you can. If you already have business loans, you should pay them off before looking for a new loan. Freshour says you might also consider lowering the loan amount you’re looking for. “If the new loan is pushing your DSCR below 1, then a smaller loan amount can help get your DSCR where it needs to be to get approved.”

Keep the debt service coverage ratio high

Having a good DSCR can certainly help you get approved for a loan, but it doesn’t stop there. As part of your loan agreement, lenders may require you to maintain your debt service coverage ratio at a certain level year after year. If your DSCR drops below that level, the lender can write off the balance due. Calling the balance due means you have very little time (90-120 days) to pay off the balance in full. If you don’t, you will be considered delinquent and the lender may initiate collection proceedings.

For obvious reasons, you don’t want to be in this position. Be sure to keep an eye on your business operating expenses, incoming revenue, and overall level of debt each month to meet your loan agreement at the end of the year.

Despite your best efforts, if your DSCR continues to decline, according to Persing, you may want to consider refinancing the loan. Restructuring the loan for lower monthly payments can make debt service coverage more feasible for you again.

What does DSCR mean and how to calculate it: Conclusions

The debt service coverage ratio is an important financial criteria that lenders use to decide if you qualify for a business loan. Make sure you calculate it before approaching lenders, take steps to improve it if necessary, and monitor it on an ongoing basis. This will help you get the financing you need to grow your small business.

Keep reading: