Lenders use a number of factors to gauge your business’s creditworthiness and “debt service coverage ratio” (or DSCR) is near the top of the list. Like your business credit score, debt service coverage ratio is an indicator of how likely you are to repay loans, lines of credit and other debt obligations.
Your business’s DSCR isn’t set in stone and there are a few things you can do to improve it and increase your odds of qualifying for financing. Here’s what you need to know about debt service coverage ratio, and why it matters for small business financing.
What is your Debt Service Coverage Ratio?
DSCR refers to the amount of available cash your business has on hand compared to the amount of debt it has outstanding. It’s a way to determine whether your business has the financial capacity to take on additional debt and keep up with debt repayments.
There’s a very simple formula for calculating DSCR. It looks like this:
Annual net operating income/Annual debt service = Debt service coverage ratio
Net operating income: This is revenue from your business minus operating expenses and your costs of goods sold (COGS).
Annual debt service: This is money required over the course of the year to repay debts including loan principal, loan interest, loan fees, and, if applicable, lease payments.
For example, if your business has an annual net operating income of $500,000 and annual debt payments of $100,000, your DSCR would be 5. Essentially, this means you could pay your debts five times over from your business income.
You don’t necessarily need to aim for a number that high, however. According to Nav, a DSCR above 1.25 is considered good and sends the signal to lenders that you’ll be able to repay what you borrow.
Note: You can swap out EBITDA (earnings before interest, taxes, depreciation and amortization) for net operating income in the DSCR formula. To calculate EBITDA, subtract all business expenses from annual revenues, then add in taxes, interest, depreciation and amortization.
What type of business debt is included in the DSCR formula?
If you’re estimating your DSCR in anticipation of applying for a business loan, it’s important to factor in every type of debt your business has. That includes:
Term loans owed to banks, credit unions and online lenders
Short-term loans, including merchant cash advances, purchase order financing, and inventory financing
Invoice factoring or financing
Real estate and equipment leases
Income tax debts paid under an installment agreement
If you’re in doubt about whether to include a specific debt, it’s better to err on the side of caution. Any debts that directly affect your business cash flow should be factored into your estimates, as lenders will do the same when calculating DSCR.
Why is your Debt Service Coverage Ratio important?
Your DSCR is important to lenders because it’s one tool they use to gauge risk. Lenders want as much reassurance as possible that your business can repay what you’ve borrowed.
Every financer sets different guidelines on the minimum DSCR required for a loan. Some, for example, require a minimum of 1.15 while others may increase it to 1.25 or higher. And you may have to demonstrate a better DSCR when borrowing larger amounts of money for your business.
But which lenders use DSCR? Not all of them do but the Small Business Administration definitely takes it into account for 7(a) loans over $350,000. Banks and online financers, including peer-to-peer lenders, may also check your debt service coverage ratio.
Aside from knowing why it matters to lenders, it’s also helpful for you to understand your DSCR before taking on any new loans. Specifically, calculating your debt service coverage ratio can tell you if it’s wise to take on new debt to your business.
Interpreting your DSCR
Understanding your DSCR requires doing some simple math and analyzing the results. You just need to know your annual net operating income (or EBITDA) and debt service numbers.
Say, for example, that your business has a net operating income of $150,000 and total debt service of $150,000. In that scenario, your DSCR would be 1. That means you’re generating enough income to repay your debts, but you may not have much flexibility with your cash flow.
Now, assume that taking on a new loan would increase your annual debt service to $155,000. That would recalculate your DSCR to 0.97, meaning you’d be able to meet 97% of your debt obligations. In that scenario, taking on more debt could be problematic if you’re not simultaneously increasing your net operating income.
If you were to grow net operating income to $200,000, for instance, having $155,000 in debt service would result in a DSCR of 1.29. This means your business has enough cash flow to pay debts while also meeting other financial needs or goals.
How to improve your Debt Service Coverage Ratio
Before you apply for a loan or another type of business funding, consider what you can do to make your DSCR more favorable in a lender’s eyes. There are two broad options for improving debt service coverage ratio: increase revenues or decrease expenses.
On the revenue side, you might consider adding new products or services or expanding your marketing reach to connect with a new client base. Raising prices is another possibility if you can do so strategically. Or you may consider entering into a partnership with another business in the same or a different niche to run a joint sales promotion.
With expenses, it’s helpful to thoroughly review everything your business spends money on monthly. Your accountant can help you go over the books and take a granular look at which operating expenses you may be able to reduce or eliminate. They can also help you determine whether it’s possible to retire some of your existing debt to remove those payments from the DSCR equation altogether.
Bottom line? Don’t skip checking your DSCR if you need small business financing. Understanding how lenders will evaluate your business’s financials can help you put your best foot forward as you prepare to apply for a loan.
Disclaimer: Fundbox and its affiliates do not provide tax, legal or accounting advice. This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal or accounting advice. You should consult your own tax, legal and accounting advisors before engaging in any transaction.