Applying for small business loans can be stressful. But it wouldn’t be so bad if you knew exactly what lenders are looking for, right? One of the important factors in lending decisions is your debt service coverage ratio (DSCR). But what is the DSCR and how can you figure out what yours is? Debt Service Coverage Ratio (DSCR) evaluates your business’s ability to repay the debt by dividing your net operating income by your total debt and interest payments.
It is one of the main ways in which a lender evaluates the financial life and health of your business. Your DSCR can influence whether you get approved for a business loan, how much you qualify for and the loan terms.
In this post, we will cover everything you need to know about the debt service coverage ratio. We will also provide you an insight on what a DSCR is, how to calculate your debt service coverage ratio, what a good DSCR looks like, how to increase your debt service coverage ratio and more.
Incorporate finance, the Debt Service Coverage Ratio (DSCR) is basically a measurement of the cash flow available to pay current debt obligations. The ratio net operating income as a multiple of debt obligations due within one year, including interest, principal, sinking-fund and lease payments.
On the other hand, in government finance, a DSCR is the number of export earnings needed to meet annual interest and principal payments on a country’s external debts.
And, in personal finance, a DSCR is a ratio used by bank loan officers to determine income property loans.
In each case, the ratio demonstrates the ability to service debt given a particular level of income.
The debt service coverage ratio (DSCR) measures the relationship between your business’ income and its debt. Your business’ DSCR is calculated by dividing your net operating income by your current year’s debt obligations. The debt service coverage ratio is used by lenders to analyze if your business generates enough income to afford a business loan. Lenders also use this number to determine how risky your business is and how likely you are to successfully make your monthly payments for the length of the loan.
The debt service coverage ratio is crucial for two reasons:
The debt service coverage ratio is a good way to monitor your business’ health and financial success. By evaluating your DSCR before you start applying for loans, you can know whether or not your business can actually afford to make payments on a loan.
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A high DSCR displays that your business generates enough income to manage payments on a new loan and still make a profit. On the other hand, a low DSCR indicates that you may have trouble making payments on a loan, or may even have a negative cash flow.
If this is the case, you may have a need to enhance your DSCR before taking on more debt. In this way, knowing your DSCR can help you analyze your business’ current financial state and help you make an informed business decision before applying for a loan.
For lenders, the debt service coverage ratio is significant as well. Your DSCR is one of the main indicators where lenders look at when evaluating your loan application. Lenders use the DSCR to analyze how likely you are to make your monthly loan payments.
They also look at how much of an income you need to cover any fluctuations in cash flow while still keeping up with payments. This ratio can also help lenders determine the borrowing amount they can offer you.
More likely to qualify for a loan.
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The formula for calculating the debt service coverage ratio requires both net operating income and total debt service of the entity. Net operating income is a company’s revenue, subtract it’s operating expenses, not including taxes and interest payments. It is usually considered the equivalent of earnings before interest and tax (EBIT).
Here is the formula that is required to calculate the debt service coverage ratio:
DSCR = Net Operating Income / Total Debt Service
Net Operating Income = Revenue – Certain Operating Expenses (COE), and
Total Debt Service = Current Year’s Debt Obligations
Some calculations have non-operating income in EBIT, however, which is never the case for net operating income. As a lender or investor comparing different companies’ credit-worthiness, or a manager comparing different years or quarters, it is important to apply consistent criteria when calculating DSCR. As a borrower, it is important to note that lenders can calculate DSCR in slightly different ways.
Total debt service is referred to as current debt obligations, meaning any interest, principal, sinking-fund and lease payments that are due in the coming year. On a balance sheet, this will add short-term debt and the current portion of long-term debt.
Income taxes complicate DSCR calculations because interest payments are tax-deductible, while principal repayments are not. A more error-free way to calculate total debt service is therefore to compute:
TDS = Interest x (1 – Tax Rate) + Principal
TDS = Total Debt Service
To create a dynamic DSCR formula in Excel Spreadsheet software, you would not simply run an equation that divides net operating income by debt service. Rather, you would title two successive cells, such as A2 and A3, “Net Operating Income” and “Debt Service”, respectively. Then, adjacent from those in B2 and B3, you would place the respective figures from the income statement. An enter a formula for DSCR that uses the B2 and B3 cells rather than actual numeric values (e.g., B2 / B3).
It is best to leave behind a dynamic formula that can be adjusted and recalculated automatically. One of the major reasons to calculate DSCR is to compare it to other firms in the industry and these comparisons are easier to run if you can simply plug in the numbers and go.
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Lenders will routinely assess a borrower’s DSCR before applying for a loan. A DSCR of less than 1 means negative cash flow, which means that the borrower will not be able to cover or pay current debt obligations without drawing on outside sources – without, in essence, borrowing more.
For example, a DSCR of 0.95 means that there is only enough net operating income to cover 95% of annual debt payments. In the context of personal finance, this would mean that the borrower would have to delve into his or her personal funds every month to keep the project afloat.
Generally, lenders frown on negative cash flow, but some allow it if the borrower has strong resources outside income. If the debt service coverage ratio is near to 1, say 1.1, the entity is vulnerable and a minor decline in cash flow could make it unable to service its debt.
Lenders may, in some cases, need that the borrower maintain a certain minimum DSCR while the loan is outstanding. Some agreements will ponder a borrower who falls below that minimum to be in default. A current debt obligation.
The minimum DSCR a lender demand can depend on macro-economic conditions. If the economy is growing, credit is more instantly available and lenders may be more forgiving of lower ratios.
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All lenders have their own criteria for calculating Debt Service Coverage Ratio, but in general, you stand the best chance of qualifying for a business loan if your DSCR is greater than 1.25. All else being equal, the higher your DSCR is over 1.25, the greater the chance that you will be approved for the loan and the better terms you’ll get.
Here is what your Debt Service Coverage Ratio tells about your business:
Your business has enough income to pay its debts and there is kind of a cushion, even if there is some variance in the business’ cash flow. For example, a DSCR of 1.25 means that your business makes 25 percent more income than it needs to cover its debts.
All of your business’s net income is going to paying debts. While this is better than having a negative cash flow, your business is still vulnerable to even the smallest drop in earnings.
Your business is not generating enough income to pay its debts. For example, if your DSCR is .95, you have enough income to pay only 95 percent of your debts. In order to pay the rest, you would have to use personal sources of income and this is not something that a lender would be comfortable with. A thriving business should be able to sustain itself without resort to personal income.
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Remember that your lender may be willing to look slightly at lower DSCR if other aspects of your application, such as business revenue and credit score, are very strong.
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If you require a higher DSCR to qualify for a business loan, you can either increase your business revenues, lower your business expenses, or lower the amount of outstanding debt that you have. Doing all of these things together has the highest impact. To increase your business revenues, you might try selling more products or services or increasing prices. For instance, Freshour suggests bringing on a co-owner with high income and low debt if the lender you are working with considers personal income when calculating DSCR. This will improve the overall DSCR of the business.
Another suggestion is to minimize your business’ operating costs. Charles N. Persing, a CPA, and Partner at Bederson LLP say there is a long list of things a small business owner can do to make a business more efficient and profitable! For example, you can ask your suppliers for better deals or put off big capital expenditures unless absolutely necessary. Automating as many things as you can also reduce costs.
You should also focus on reducing your debt as much as you can. If you have existing business loans, pay them down before seeking a new loan. Freshour says you might also want to consider reducing the loan amount that you are seeking. “If the new loan is taking your DSCR below 1, then a smaller loan amount may help get your DSCR where it needs to be for approval.”
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But it does not stop there. As part of your loan agreement, lenders may want you to keep your debt service coverage ratio at a certain level year over year. If your DSCR declines below that level, the lender may call the balance due. Calling the balance due means having a very short amount of time (90-120 days) to pay off the full balance. If, however, you fail to do so, then you will be considered delinquent and the lender can initiate collection proceedings.
For obvious reasons, you do not want to be in this position. And ensure that you keep an eye on your business’ operating expenses, incoming revenues, and overall debt level each month so that you are in compliance with the loan agreement at year-end.
Instead of your best efforts, if your DSCR keeps declining, Persing says small business owners can consider refinancing the loan. Restructuring the loan so that there are lower monthly payments can get your Debt Service Coverage back in the clear.
Debt Service Coverage Ratio (DSCR) is an important financial yardstick that lenders use to decide if you qualify for a business loan. Ensure you calculate it before approaching lenders, take steps to improve it if necessary and monitor it on an ongoing basis. This will help ensure that you can get the financing you need to grow your small business.