Debt Service Coverage Ratio
Lenders use a range of metrics and tools to determine if a borrower is trustworthy and can afford the loan payments. This is true whether the lender is dealing with individuals or businesses.
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Where the former is considered the lender may use something known as a debt-to-income ratio, which compares total income to total monthly payments. For businesses, something known as a debt service coverage ratio or “DSCR” is used. This ratio is one of the most important numbers tied to your business and in this guide, we’ll show you why.
What is a Debt Service Coverage Ratio?
Your DSCR ratio is used when you apply for a business loan. A lender will run the numbers to determine if you have the necessary cash to make the loan payments. This is imperative on long-term debt as well as lease payments and provides some assurances to the lender that the borrower will not default on their obligations.
How to Calculate Your Debt Service Coverage Ratio
To get your DSCR, you first need to calculate your net operating income and then divide this by your debt obligations for the year.
Your net operating income is all of your company’s revenue minus operating costs.
As an example, if your revenue is $1 million, but half of that goes on repairs, maintenance, insurance, property taxes, utility bills, and more, then your operating income is $500,000. If you have debts of $500,000, then you’re breaking even and your DSCR is 1.00x. If your debt service coverage ratio is below 1.00, then you’re running at a loss and may struggle to get the credit you seek.
If your DSCR is 1.50x, this essentially means that you have 50% more income than debts. For instance, if you have a small business with a net operating income of $100,000 and debt payments of $50,000, then your ratio will be 1.50x, which is very positive.
Unlike your debt-to-income ratio, which is best when it’s low (as it’s calculated based on how much of your income is allocated to debt) your debt service ratio essentially covers the opposite, so it’s best when it’s high.
What is a Good Debt Service Coverage Ratio?
The higher your DSCR is, the better. However, lenders understand that businesses often run on very fine margins and will not expect you to be generating huge profits. Generally speaking, lenders will require a ratio of 1.20x or more before they offer you a substantial loan, such as a mortgage. However, you may still qualify for another loan or line of credit even if your DSCR is less than this.
As long as you can meet the payments, they won’t mind, so providing you don’t have negative cash flow resulting from massive debts, capital expenditures, and other operating expenses, you should be okay.
It’s important to understand your DSCR at all times as it provides you with some valuable insight into the operation of your business. A bad DSCR means you may have more debt obligations and payments than you can handle; a good DSCR suggests a positive cash flow, which looks great to investors and hints at a very positive future for your business.
Best Way to Calculate
If you’re just looking for a quick calculation to give you an overview of your financial situation, you can use some of the basic information you have already (net income, operating expenses, annual debt). For a more detailed calculation that can help you better understand your current financial situation and your future financial prospects, you can use accounting software or Microsoft Excel.
This will allow you to create detailed sections for:
- Net Operating Income (total revenue for the year)
- Operating Expenses (including utilities, depreciation, and maintenance)
- Annual Debt (loan debt, lease payments, credit lines)
- Taxes (including taxes depreciation)
Benefits of a Good Debt Service Coverage Ratio
A good debt service coverage ratio means your business has lots of positive cash flow and is:
- Considerably more likely to qualify for a loan
- More likely to be offered favorable rates on that loan
- More likely to get beneficial perks and a higher loan amount
It’s not just lenders, either. Investors and potential buyers will also use calculations like your debt service coverage ratio to determine the financial health of your business and decide if it’s a risk worth taking.
What Happens When your Ratio is Poor?
If your DSCR is low, you may struggle to get a mortgage or other major loan. It indicates that you have a poor net operating income or debt payments that are bleeding you dry every month. If you do receive an offer, it’s likely to have a much higher interest rate and less favorable terms.
Lenders offer better rates to individuals and businesses with more positive cash flow because they are statistically more likely to repay their debts. By offering higher interest rates to those with poor cash flow and excessive debts, they can recover some of those costs from the higher percentage of defaults that occur with these borrowers.
The good news is that lenders don’t care what your ratio was several years ago. They may ask to look back over previous year’s accounts, but they won’t dig deep, and, in most cases, if you have a high debt service coverage ratio and a positive cash flow now, you’ll get the loans and the rates you seek.
How to Improve Your Debt Service Coverage Ratio
If your payments are high, your cash flow will be poor, and your debt service coverage ratio will be low. If this happens, it’s time to turn things around, not just to make it easier to acquire favorable rate loans, but also to ensure the continued success of your business.
There are a few ways that you can improve this ratio and get your business back on track:
Increase Net Operating Income
This is easier said than done and it’s certainly not going to be a Eureka moment (if only we’d thought of that!). However, it needs to be said, because it’s the best way to improve your DSCR and the chances of acquiring a loan.
Improving your net operating income is not just about getting more sales, you can also make some sacrifices to trim some expenses and improve your profit. Here are some tips to consider:
- Increase your prices.
- Utilize different marketing strategies.
- Find and remove unnecessary expenses.
- Negotiate discounts with suppliers and utilities.
- Remove products from sale if they’re not generating much profit and cost too much to produce/make/store.
One of the costliest mistakes that big businesses make is to throw money at unnecessary expenses simply because it only accounts for a small percentage of their total budget. If they’re earning $1 million a year and spending half of that, they’re not going to think twice about an additional expense that costs just a few hundred or thousand dollars.
But these things add up. It’s a similar situation to the one that countless American families find themselves in. They don’t think twice about a $20 media subscription or a $50 to $100 luxury expense every now and then. But these costs mount up quickly and before they know it, they’ve blown in excess of $5,000 over the year.
It’s the same story with businesses—every dollar counts and unless it’s essential for the continued growth of your business, it’s an expense you can do without.
Pay Off Debt
Your annual debt is key to your DSCR. The more of this you have, the lower that your DSCR calculation will be. It’s important to repay this debt whenever you can. It doesn’t matter if you can’t repay it in full, just pay what you can.
Interest compounds, debt grows, and every time you pay only the minimum amount, you’re covering just a fraction of the principal. If you have a little money left over every month, put it towards the debt. Depending on the debt, an additional payment of just $100 could save you an additional $100 in interest over the term and it will also reduce that term. And because your DSCR score calculates your annual debt and not your monthly debt, a few small extra payments every now and then could have a significant impact on the bigger picture.
The more of these payments you make, the less interest you will pay and the faster those debts will clear. Take a look at our guide to Pay Off Debts and How to Get Out of Debt to learn more about this process.
You can also use a strategy like debt avalanche or debt snowball to repay loan debt in full. These strategies are designed for individuals and not businesses, but the same principles apply—just focus on the loan with the smallest balance or the loan with the highest interest. Once that loan has been repaid, move onto the next one.
Every loan that you clear will move you one step towards a better DSCR and an improved chance at securing a mortgage loan or another major loan.
Businesses borrow money. It’s a fact of life, and, in most cases, they need to borrow to make their business profitable or viable in the first place. Debt obligations are a fact of life in the business world and most businesses will only seek to improve their DSCR so they can acquire an additional loan.
However, it’s important to keep high-interest rate loans and unnecessary loans to a minimum. These may not affect your net operating income, but they will make your business less profitable, which means it becomes less of a viable option for potential buyers, investors, and lenders.
Lenders are quick to lend to brand-new businesses and often use aggressive marketing targets to target them, waving the promise of easy money in front of their faces and hoping they will ignore the high rates and bad terms.
If you want to succeed in the long term and get the loans that matter, you need to keep these loans to a minimum. That means no high-interest business credit cards or short-term loans. Lend money to the business from your own pocket, ask friends and family or simply grow the business slowly. Whatever you do, these debts need to be avoided.
Important (but not Essential) to Know
It is important to know what your DSCR is, just as it’s important to know what your operating income is and what your debt obligations are. However, if you have an accountant doing all the calculations for you and you’re not interested in acquiring a loan or mortgage anytime soon, it’s not something you need to concern yourself with right now.
Just keep an eye on your operating income and your debts, watch the bottom line, and focus on growing the business with as little debt as possible. You can worry about your DSCR when it becomes the deciding factor in determining whether you will get a new loan or not.