United States
Updated: May 8th, 2023
Debt service coverage ratio (a mouthful we and others abbreviate as DSCR) is an important metric for small business owners who have borrowed or plan to borrow money.
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We’ll walk you through why lenders care about DSCR, how to calculate it for small businesses, and what the ratio means for your ability to qualify for a loan.
The debt service coverage ratio (DSCR) is a way to measure how much cash a business has to pay current debt obligations. DSCR is calculated by dividing net operating income by your annual debt obligations (including sinking fund payments).
Lenders use it as a metric to determine whether or not a business can afford a loan.
Lenders use DSCR to evaluate how much capacity your business has to pay back their loan. They want to be certain that you have sufficient regular cash flow over the term of the loan to make your monthly payments. It’s also an important way for you to evaluate the financial health of your small business.
In addition to determining your business’s financial health and helping you qualify for loans, DSCR can also be a valuable tool to use during strategic growth planning.
High debt obligations can stop reinvestment and halt growth projects. Negative cash flow makes scaling a business pretty challenging. By calculating your total DSCR, you can use it to determine opportunities and appropriate strategies.
| Net Operating Income | Annual Debt Obligation |
|---|---|
| Your Net Operating Income is the revenue from your business minus your cost of goods sold (COGS) and your operating expenses. Operating expenses do not need to include taxes, interest payments, depreciation, and amortization. | Your Annual Debt Obligation is the current year’s payments of loan principal, loan interest, loan fees, and, if applicable, lease payments. This includes payments on all business obligations that you currently have and the loan you’re applying for. |
Interpreting DSCR numbers:
The calculation above will produce your DSCR ratio:
| DSCR < 1 | DSCR = 1 | DSCR > 1 |
|---|---|---|
| A DSCR below one means that you don’t have the ability to pay your debts in full. For example a DSCR of .97 means that you only have the ability to pay 97% of your annual debt payments. This means you probably should not be borrowing more money. | A DSCR of one indicates that 100% of your business’s net income is going towards paying your debts. While this is sustainable in theory, it leaves you very vulnerable to any variation in your cash flow. | A DSCR above one means that your business is generating enough income to pay its debts. For example, a DSCR of 1.20 means that you are making 20% more income than you need to cover your debts. |
Lenders are looking not only for a DSCR above 1 (meaning you can repay their loan), but some degree of cushion above that to account for uncertainty).
The exact value that lenders are looking for depends on the specific lender and the general economic climate — lenders become more risk averse when the broader economy is not doing as well.
At Funding Circle, we require a DSCR of 1.15 to approve a loan.
If you plan on applying for a loan, calculating your DSCR will help you determine the loan amount that’s best for your business.
Calculating your DSCR in advance shows your prospective underwriter that you understand the fundamentals behind the loan they might provide and how it will impact your business. It’s also an important metric to track in general to understand the health of your business.
As an example, a business with a net income of $100,000 and an annual debt obligation of $50,000 has a DSCR of 2.
This means that the hypothetical business’s net income can cover its debt obligations twice over — they’re doing great!
A DSCR is a good gauge of your company’s financial health, so it’s important to get it right the first time. Here are some common mistakes people make when calculating the debt service coverage ratio and how to avoid them.
Calculating your total outstanding principal and interest obligations can get complicated – especially if there are multiple lenders involved, different debt forms, and principal payments that aren’t on income forms.
Make sure your accountant or bookkeeper double-checks your calculation. Don’t hesitate to verify amounts with individual bank loan officers.
You can use either your EBITDA (short for earnings before interest, taxes, depreciation, and amortization) or your EBIT (earnings before interest and taxes) to calculate DSCR. In general, its recommended that you use EBITDA when determining your company’s ability to pay debt; however, be sure to verify with your personal accountant or financial professional and lender to determine the right choice for your business.
Note: Income taxes make calculating DSCR even more complicated since interest payments are tax deductible, while principal repayments are not. Stick with the EBITDA for simplicity’s sake.
To improve your DSCR, you need to improve your business fundamentals and/or adjust the loan terms. Here are some options:
Remember that DSCR improvement is not a one-time event and requires ongoing financial management and monitoring.
We assume that you’re already interested in generating more cashflow (duh) and have a couple of resources to help you out if you need more information.
Our suggestion is that you use DSCR to evaluate how much you should be borrowing. If your DSCR is too high, a smaller loan may be better for the health of your business in the long run.
Apply for a loan with Funding Circle to help you take your business to the next level this year!
Louis DeNicola is the president of LD Money Media LLC and an experienced finance writer who specializes in credit, personal finance, and small business finance. Within the small business sphere, he helps business owners understand their financing options, cash flow management, business credit, and taxes. In addition to Funding Circle, you can find his work on BlueVine, Credit Karma, Experian, Wirecutter, and Lending Tree.
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