Factors such as your credit history, business assets and debt service coverage ratio play an important role in helping lenders decide whether you’re a risky investment or not — but it’s impossible to know which factor a lender will care about the most. Learn what a debt service coverage ratio, or DSCR, is and why it’s important in our guide below.
The debt service coverage ratio (DSCR) — also called a debt coverage ratio (DCR) — is an industry measure of the cash income a business has leftover at the end of the month that can be used to service its debt (including principal, interest and lease payments).
A high DSCR means you have a substantial amount of money leftover at the end of the month after all of your expenses have been payed – money you could put towards loan repayments if you got a new loan. A low DSCR means you’re just barely meeting your expenses by the end of the month, with very little money leftover
Any time you apply for a loan at a bank or any other traditional financial institution, the lender will use your DSCR to decide whether your business will be able to manage its repayments. The higher your debt service coverage ratio, the better.
Simply put, the DSCR is one of the main benchmarks used to determine your ability to make repayments. If your business isn’t generating the income it needs to pay its debt and make repayments – meaning your DSCR is low – then a lender will likely decline your loan application.
Your business’ DSCR is immensely important to the process of applying for a business loan. Although other factors such as credit history, time in business and loan collateral will be considered as part of your loan application, if your ratio is too low, you’ll likely be denied for the loan altogether.
In general, a ratio of 1.2 is the minimum debt service coverage ratio that a lender is willing to accept. However, depending on the type of industry your business operates in, your lender may have a higher or lower minimum ratio.
To calculate your debt service coverage ratio, use the following calculation:
Your debt service coverage ratio (DSCR) = Annual business operating income ÷ Total annual debt service level (principal and interest you must repay in a given year)
Lenders may use different figures when assessing your operating income. Some will use EBITDA (earnings before interest, taxes, depreciation and amortization), while others will add net operating income to depreciation and any other non-cash charges. As a result, the DSCR figure won’t be the same across all lenders, which can make direct comparison difficult. Some also express the DSCR as a percentage rather than a ratio.
To illustrate how the DSCR works, let’s assume your business has a total annual net operating income of $80,000 and you’re applying for a loan with an annual debt service of $30,000 (including annual interest payments). Let’s say you also already have a long-term loan you’re currently paying off at $40,000 of annual debt service.
So, you’ll need to factor in both the loan you’re applying for and the loan you already have – bringing your total annual debt service to $70,000. To calculate your DSCR, take your annual net operating income of $80,000 and divide it by your annual debt service of $70,000.
This would equal a DSCR of 1.14, a low ratio that would likely prevent your application from being accepted. This essentially means you’d have $1.14 to pay off every $1 you’d owe in debt – which means you’d be leftover with $0.14 after paying every $1 in debt.
Keep in mind that if you’re able to use future financial projections to convince the lender that your second loan would increase your income/profits to boost your DSCR enough, then you could be accepted.
You should always be careful of getting into too much debt, whether it’s personal or business related. But when your business is in need of cash, being fully aware of the debt service coverage ratio and how it factors into the decision-making process of a lender will help better prepare you when applying for a business loan.
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