This article is part of a larger series on Business Financing.
While credit scores and income are important factors for a lender when approving business loans, another calculation can make the difference between loan approval and denial. The debt service coverage ratio (DSCR) measures your business’s ability to repay a business loan.
The DSCR compares your annual business debt to your annual business income. While each lender will have different requirements for a DSCR, in general, a DSCR of 1.25 or higher is required for most business loans and invoice factoring.
How To Calculate the Debt Service Coverage Ratio
The calculation for a DSCR is relatively simple, using the following formula:
DSCR = Business annual net operating income / current year’s debt obligations
- Calculate business annual net operating income: Net income is business revenues minus operating expenses―except taxes, interest payments, depreciation, and amortization, which should be added back in when calculating income, along with the owner’s salary and one-time expenses that are nonrecurring.
- Calculate business debt obligations for the current year: Add up the current year’s loan principal payments, loan interest, loan fees, and lease payments. Include the projected payment for the loan being applied for as well. If a loan is being refinanced, use the new projected payment instead of the old loan payment amount.
- Divide the net operating income by current debt service: This gives you the DSCR. Use our calculator below.
Example 1: Your business has a net operating income of $100,000. Your annual debt obligations are $40,000. Your business has a DSCR of $100,000/$40,000, or 2.50.
Example 2: Your business has a net operating income of $50,000. Your annual debt obligations are $75,000. Your business has a DSCR of $50,000/$75,000, or 0.67.
In example 1, your business will likely qualify for the loan based on the DSCR. However, in example 2, the loan application will likely be denied due to a DSCR lower than 1.25. The business in example 2 can only meet 67% of its current obligations.
What Does the DSCR Mean for My Business?
Lenders usually require businesses to have a DSCR of higher than 1.25. So, here’s what that number means in terms of the financial health of your business:
- DSCR greater than 1: Your business has enough income to pay its debts, with a cushion in the event of a fluctuation in cash flow. For example, a DSCR of 1.25 means that your business makes 25% more income than it needs to cover its debts.
- DSCR equal to 1: All of your business’s net income is going to pay debts. This means any drop in cash flow could cause significant problems for your business.
- DSCR less than 1: Your business isn’t generating enough revenue to pay its debts. A DSCR of 0.95 means you’re paying only 95% of your business’s debts. To cover the remainder of the debts, a business owner would have to use personal income. A lender would likely look at this business as unhealthy financially and would likely deny any loan applications.
How To Improve Debt Service Coverage Ratio
Because the DSCR is a simple formula, the changes that must be made to improve the ratio are fairly apparent. To raise a DSCR, business revenues must increase, business expenses must decrease, or business debts must decrease.
While you can increase sales or raise prices to raise revenues or pay off debts to decrease obligations, these things can’t always be done quickly. If you have plans to borrow money in the future, you should keep close tabs on your business’s DSCR. This way, you can make gradual changes and ensure the number is above 1.25 before beginning the loan application process.
If your business has a borderline DSCR and is close to qualifying for financing, taking out a smaller loan could reduce the debt side of the equation enough to qualify.
Importance of Keeping a High DSCR
By having a solid long-term financial plan, you can ensure your DSCR is high enough before applying for financing. However, there’s another reason to keep a DSCR high: many business lines of credit require annual financial reporting with updated income and debt information.
If a business doesn’t keep its DSCR high throughout the life of a line of credit, the lender may choose to reduce the maximum credit limit or close the line of credit altogether. This could significantly hamper the financial stability of a business.
The debt service coverage ratio compares your business’s annual net revenue against its annual debt obligations. A business should keep its DSCR above 1.25 to qualify for loans and keep its financial health stable. Business owners often keep a close eye on credit scores. However, you should keep just as close an eye on your DSCR. A low DSCR can have the same negative impact on your company as a low credit score.