For the entrepreneur seeking financing to grow a business, financial ratios take on heightened importance. Of course, ratios are crucial in measuring the health of your business in general.
However, when you’re applying for business loans specifically, ratios are another yardstick for lenders to use to access your eligibility for a loan. They help answer whether or not your business can take on a loan, how big a small business loan you can handle, and what terms you’ll get on the financing.
One of the financial ratios that every small business owner should understand is the debt-service coverage ratio. Don’t know what a debt-service coverage ratio is, or how to calculate it? Here’s a quick tutorial.
What is Debt-Service Coverage Ratio?
In a business context, the debt-service coverage ratio (DSCR), sometimes called the debt coverage ratio (DCR), is the ratio of cash a business has available for servicing its debt — including making payments on principal, interest and leases. A DSCR of greater than 1 shows that the business has enough income to pay current debt obligations.
Why is the Debt-Service Coverage Ratio Important?
The debt-service coverage ratio is one of many financial ratios that lenders assess when considering a loan application, and it’s crucial to any small business owner looking for business financing.
Obviously, the biggest concern on a lender’s mind is whether or not the loan recipient will be able to pay the loan back or not. Lenders don’t want to lose their investments, so they’re looking for reassurance that your business has generated, and will continue to generate, enough income to pay back the loan with interest.
In fact, lenders also want to see that you have some “cushion” — cash flow above and beyond the minimum needed to pay off the loan. If you barely generate enough income to cover the debt service, your business is not doing well enough to warrant a loan. Every small business owner knows that unexpected things come up. If you don’t have a cushion on your business’s cash flow, you might not be able to cover your loan repayments if your business is strapped for cash. So, when lenders look at your debt-service coverage ratio, they’re looking to see how much extra cash you have on hand to cover your loan payments and run your business comfortably, too.
What is an Ideal Debt-Service Coverage Ratio?
Every lender has a minimum debt-service coverage ratio requirement for approving a business loan. The exact DSCR they’re looking for will depend on their business loan requirements.
As previously mentioned, a DSCR of greater than 1 shows that you have sufficient income to cover your current debt obligations. A DSCR below 1, however, shows that you do not have enough cash on hand to comfortably cover your loan payments.
In general, lenders are looking for debt-service coverage ratios of 1.25 or more. In some cases, when the economy is doing great, they might accept a ratio as low as 1.15; in others, when the economy is tight, they may require a ratio of 1.35 or even 1.5. Bottom-line: the higher your ratio, the better your chances of getting a business loan in any economy.
Before approaching a small business lender for a business loan, you need to calculate your debt-service coverage ratio, and take steps to improve it if it’s not up to par. The financial projections in the business plan you present to prospective lenders should include the debt-service coverage ratio for the next three years. In addition, if you have a growing business, or are seeking a loan to buy an existing business, the lender will want to see debt-service coverage ratios for the past three years. That way, they’re not just relying on projections; instead, they can see evidence that your business was thriving and will be in the future.
How To Calculate Your Debt-Service Coverage Ratio?
There is no one answer to this question. Different lenders might calculate the figure differently. However, essentially, a debt-service coverage ratio is calculated by dividing total annual net operating income by total annual debt service.
Two Ways to Calculate DSCR
- Annual Net Operating Income + Depreciation & Other Non-Cash Charges / Interest + Current Maturities of Long-Term Debt.
- EBITDA (Earnings Before Interest, Taxes, Depreciation & Amortization) / Interest + Current Maturities of Long-Term Debt
These calculations will give you a figure that should be taken to the second decimal point.
An Example of a DSCR Calculation
Let’s say your business’s total annual net operating income is $20,000 and you’re applying for a loan with a debt service that will cost $16,000 each year. This means that your debt-service coverage ratio will be: $20,000 / $16,000 = 1.25
With a debt-service coverage ratio of 1.25 (in a strong economy), you should be set for applying to a business loan.
Bear in mind, of course, that the lender will also consider any current debt service you have before applying for the loan, so you need to figure that into the calculation.
In the example above, if you already had debt service of $4,000 annually, taking on a new loan with debt service of $16,000 would bring your total annual debt service to $20,000.
This means that your debt-service coverage ratio with your current debt-service would be:
$20,000 / $20,000 = 1.0
This is not enough to obtain a loan, unless you are able to use financial projections to convince the lender that getting the second loan will enable you to increase net operating income to a point sufficient to boost your debt-service coverage ratio to respectable levels. While this is possible, it’ll be hard to get that 1.0 debt-service coverage ratio out of your lender’s mind.
Monitoring Your Debt-Service Coverage Ratio
Clearly, maintaining a good debt-service coverage ratio is important whether or not you are applying for a loan. Your ratio will not only affect your ability to get financing in the future, it can also determine whether the lender calls your loan early.
Your debt-service coverage ratio will go beyond your business loan application. Depending on your loan agreement, you’ll have to maintain an adequate debt-service coverage ratio while you’re in the process of paying off a loan.
In order to make sure you are staying within the terms of your loan agreement, lenders will typically require you to measure your debt-service coverage ratio every year — usually shortly after your business’s fiscal year-end. To ensure your debt-service coverage ratio doesn’t decline, causing you to violate your loan agreement, you should actually monitor it more often, e.g., quarterly, or even monthly, so you can maintain the ratio that’s needed.
Be sure you understand exactly how your lender calculates your debt-service coverage ratio so you can make sure you are using the same measurement. You can find many free debt-service coverage ratio calculators online. However, if the calculator doesn’t use the same parameters your lender does, you won’t get a correct ratio.
Now that you understand the importance of a healthy debt-service coverage ratio, take steps to protect it by monitoring and maintaining your debt-service coverage ratio. You stand a better chance of getting (and keeping) the small business loan you need to grow your company.