Debt Service Coverage Ratio: Definition and Formula
When applying for a business loan or other form of financing from a bank or creditor, you’ll likely be asked to provide certain key information about your small business’s history and future outlook. Lenders will hope to see proof of your personal creditworthiness, your business’s growth potential, and, most importantly, the viability of a lending agreement with your firm. Without confidence in your venture’s ability to grow, lending institutions will likely shy away from offering large-scale assistance to your mission. Similarly, without assurances that their loan will be repaid on schedule, a bank will likely decline your requests for financing.
To determine whether a company is able to repay a prospective loan, banks and lending groups pay particular attention to what’s known as the Debt Service Coverage Ratio (DSCR) of a firm. The DSCR provides a glimpse into the outstanding debt obligations of a company, and whether its current cash-flows and revenue statements allow those obligations to be met on schedule and in full. The DSCR is a key metric examined by lenders, so it’s essential to understand what goes into the DSCR calculation and what you can do to boost your lending profile before approaching a bank with an application.
What is the Debt Service Coverage Ratio (DSCR)?
The Debt Service Coverage Ratio is a measurement of an individual or company’s ability to pay back current debt obligations based on their present cash flows. The metric is used in corporate and personal finance to determine the viability of a lending agreement, but is particularly important for small business owners seeking financing for growth or expansion.
Basically, your firm’s DSCR weighs your company’s net operating income, or your annual income once certain business expenses are brought into consideration, versus the sum of your business’s debt obligations over the next year. You may be familiar with the commonplace lending metric known as DTI, or Debt-to-Income ratio, which describes an individual’s creditworthiness as a measure of their debt obligations and total income; an individual’s DTI holds similar implications to a firm’s DSCR, though the former applies mostly to personal financing and lending, versus commercial.
While banks and lenders will typically calculate a business’s DSCR using materials such as financial statements and rosters of outstanding debt obligations, it is important to have an understanding of the metric, and your own DSCR, in order to predetermine which loans and financing options may be available to your firm. While there’s no standard rule, certain lenders offer assistance only to those businesses with a favorable DSCR; calculating your firm’s value ahead of time can help streamline the process of applying to various loan options.
Debt Service Coverage Ratio Formula
Calculating DSCR for your business is fairly simple. To arrive at your DSCR value, simply divide your Net Operating Income, or (Annual Revenues – Certain Operating Expenses), by your annual debt obligations, or total debt service:
DSCR = Net Operating Income / Total Debt Service
DSCR is calculated on an annual basis, rather than as a monthly number, meaning that your yearly income is weighed against your annual debt service. The figure is incredibly important when applying for small business financing from reputable banks and lenders.
Why DSCR Matters
Essentially, lenders use a company’s DSCR to measure whether or not a borrower can repay their outstanding debt plus whatever new obligations may arise from a prospective financing agreement. If your small business is pressed for cash at the moment, with an unfavorable DSCR, lenders will be less likely to offer debt financing, especially long-term debt financing, out of fears that you may default on your obligations. Or, lenders may offer you a lower loan amount or higher interest rate to help mitigate their risk.
Using the simple algorithm above, banks and lenders are able gain a rough yet reliable idea of where you stand with regard to debt repayment. If your Debt Service Coverage ratio is well above 1, that means that your net operating income significantly outweighs your debts, and that your firm should have enough income to take on new obligations without worry. If your DSCR is at or just above 1, new debt may tank your balance sheet and run the risk of default, so lenders will tread carefully in offering you financing. And if your DSCR is below 1, your business is already failing to meet its debt obligations, and banks will be highly unlikely to sign onto new debt financing with your firm. Calculating your own DSCR before applying for financing can help direct your efforts at lending institutions and agreements which are more favorable to businesses at your present stage of development.
What is a Good DSCR?
Depending on the industry you operate within and the trajectory of your business’s growth, there are a range of DSCR values favorable to taking on new loans. Typically, we advise businesses to maintain a DSCR well over 1 and ideally around 1.25, meaning that your net operating income should outweigh your annual debt service for the year by about 25%. For industries which favor rapid expansion, or for businesses still investing heavily in growth, there is some leeway to those estimates; however, the law holds true that the higher your DSCR, the more likely you are to receive financing from a reputable lender.
Whatever your stage in development, no matter the value of your DSCR, it’s important to remember that there are a multitude of financing options and arrangements that are available to your small business venture. While the DSCR is often relied on to determine debt-financing agreements, other forms of financing, like equipment financing, hold less stringent criteria and may be more favorable to your young venture. Before ruling out any of your options, before you even apply to any, your best bet is to consult a loan officer or banking representative to discuss which financing routes are best for you and your company.
In the meantime, learn more about other forms of financing, like small business loans, to come prepared to any conversation with a loan expert.
Director, Marketing & Strategic Partnerships at Credibly