Debt Service Coverage Ratio: The Complete Guide for Small Business Owners
You probably already know a few of the things lenders look for when you’re applying for a loan: good credit, good cash flow, possibly some collateral. And that they also take into account not just your revenues, but also how much debt you have. But what you may not know is that there’s actually a formula many lenders use to decide if they want to loan you money.
That formula determines your debt service coverage ratio (DSCR), which is used to show how much income your business has in comparison to your debt. The DSCR is calculated by dividing your net operating income by all your business debt. Your net operating income is your revenue minus your expenses with your total earnings before interest, taxes, depreciation and amortization (EBITDA) added back in. Your annual debt obligation is how much you owe annually on principal, interest and fees toward your debt, including loans, credit cards and leases.
Why is DSCR important?
The debt service coverage ratio is both a sign of how financially healthy your business is and how likely it is you would get a small business loan.
The higher your score, the better your chance of being approved a for a new loan and getting more favorable rates, said CPA Catherine Derus, founder of Brightwater Accounting in La Grange Park, Illinois. A higher score shows that you have enough money to not only pay your existing debt but also take on that new debt. Lenders will also want to see that you have some financial cushion in case unexpected expenses pop up, Derus said. For example, if your sales dip or you need to make an expensive purchase.
“The banks are going to be fronting some of that loan money, and they want to make sure they get that money back,” Derus said.
At minimum, most lenders will want a DSCR score of 1.15, the requirement for Small Business Administration (SBA) loans. That number means you have $1.15 in income available for every $1 of debt, which includes the proposed loan debt. Many lenders will want a score of 1.2, Derus said, which means you have 20% more income than you need to cover your debt. And some may even want as high as 1.25.
How to calculate your DSCR
Knowing your DSCR score can help you figure out both if you can afford a new loan and how likely it is you would be approved for one.
To figure out your debt service coverage ratio, follow the formula:
Net operating income (or EBITDA) / annual debt obligation = DSCR
But first, you’ll need to know how to find your net operating income and your annual debt payments. To figure out your net operating income, most lenders will use EBITDA. To determine your EBITDA, you will take your business net income (your revenue minus all expenses) and then add back in your taxes, interest, depreciation, and amortization.
Step 1 Calculate your annual net operating income/EBITDA:
Annual revenues: $400,000
Cost of goods sold: $175,000
Annual net income = $37,000
Now, add back in your interest, taxes, depreciation and amortization.
Annual net income: $37,000
Annual net operating income/EBITDA = $122,000
Step 2: Calculate Annual Debt Payments (include existing loans and loans you’re applying for)
To calculate your annual debt payments, first figure out how much you’re spending on your debt obligations (loans, mortgages, leases, etc.) and multiply that by 12. Let’s say you have an existing $200,000 loan with a 3-year term and a 12% interest rate, your monthly payments (including fees) would be around $6,652 so your total annual debt payment would be $79,834.
Step 3: Divide Annual Net Operating Income by Annual Debt Payments to Get DSCR
Now you’ll need to divide your annual net operating income by your annual net operating income by your annual debt payments. In this case:
DSCR = $122,000 / $79,834 = 1.5
A DSCR score of 1.5 would be a good score since it would mean you’d have 50% more income than needed to pay your debts and you would be well above the 1.2 minimum that many lenders require.
Some lenders will use what’s known as a global debt service coverage score. That means they won’t just take into account the financial and credit history of your business, but also your personal income, debts and credit score. That would include salary if you have another job or your personal debt like a mortgage or student loan. The income and debt of your business partners and loan guarantors might even be included.
Whether the global debt service coverage ratio is a pro or con depends on the strength of your personal credit score and how much personal debt you have. If you have a very high personal credit score, it can raise your debt service coverage ratio, but on the flip side, a bad credit score can hurt your debt service coverage ratio. The same is true for how much debt and revenue you have. If you have a lot of personal income, and not much debt, that could raise your score, but too much debt can lower it.
What to watch out for when calculating your DSCR
To accurately figure out your DSCR, you’ll need to make sure you account for all your revenue and expenses. Forgetting to include any type of existing debt will throw off the calculations. That’s important since the whole point of the DSCR is to figure out how well you can handle repaying the loan you’re seeking, plus whatever debt payments you’re already making. Some types of debt like major term loans probably stand out, but you’ll also need to factor in:
- Loans from all types of lenders and of all term lengths
- Leases (cars, equipment, etc.)
- Invoice financing
- Lines of credit and business credit cards
What does your debt coverage ratio mean?
Once you’ve figured out your DSCR, you’ll have a good idea of how lenders will react to your loan application. Here are some broad ranges:
- Less than 1: That signals a net operating loss, meaning you don’t have enough money coming in to pay your debt.
- Exactly 1: Considered a “break even” score, you have enough money to pay your debt, but no cushion to handle unexpected expenses.
- Greater than 1: You have more money than needed to pay your debt. The higher your score, the more income you have. If you have a score of 1.2, that means you have 20% more income than you need to pay your debts.
“The lower your score, the less favorable loan terms you’re going to get compared to a business that’s more solvent,” Derus said.
How to improve your debt service ratio coverage
If you don’t need a loan immediately, you might want to take some steps to improve your DSCR if it’s lower than most lenders would like or not much above the minimum requirement.
To increase your DSCR, you really have two levers to pull: revenues and expenses. If you can increase your revenues, and your expenses stay the same, or your expenses go down and your revenues stay the same, your DSCR score will go up. Or you can increase your revenues and decrease your expenses for maximum impact.
Here are some tips for increasing your DSCR:
- Increase the price of your product or service if it won’t drastically impact sales
- Negotiate a lower rent or consolidate real estate
- Consider trimming down staff
- Cut back on travel expenses
- Eliminate a less profitable product line
- Refinance some of your debts
- Lower the amount of the loan you’re requesting
“Obviously, you still need to be able to run your business, but you want to see if you can increase sales without increasing your costs too much or make cuts without eating into your profits,” Derus said.
The Bottom Line
If you want to bring up your DSCR score or you already have a good DSCR score and want to keep it that way, revenue forecasting can come in handy.
A revenue forecast is an educated projection of how much money your business will make in the future over a set period of time. It can be for the next year or farther out looking at the next two or three years. That will give you a good idea of how much more you can afford to spend or if you need to cut expenses.
“If you don’t have any sort of plan in place, some idea of what you want to do with your business, and you’re just winging it, you might not actually get there,” Derus said.
And while not all lenders use the debt service coverage ratio, and they are most commonly used for larger loans, it’s still a good tool to tell you if your business is financially on the right track.