If you’ve applied for a small business loan before, you’re reasonably familiar with how a lender decides whether or not they want to work with you. Many will want to look at your credit scores (personal and business), business tax returns, monthly bank statements, and more. They’ll want to know how much money you business is bringing in, how much money is going out, and where it’s going.
Most lenders will also want to know what existing debt you and your business have. They’ll calculate what’s called a debt-service coverage ratio (DSCR), which is one financial ratio that measures your company’s free cash flow available to meet current debt obligations. The DSCR calculation is used most frequently in commercial real estate loans and in corporate finance.
How Is Debt-Service Coverage Ratio Calculated and What Does the Value Mean?
Debt-service coverage ratio is typically calculated using this formula:
DSCR = net operating income / debt service
Where net operating income (NOI) is net income plus taxes and interest payments. Net income in the number that will appear on your P&L statement; it is the revenue you brought in for the year minus the expenses you incurred.
Annual debt service is your business’s total amount of debt owed across the same period. More specifically, it is the amount of debt payments (principal and interest expenses plus any sinking fund contributions and lease payments) you’ve paid throughout the year or will pay in the year (your current and proposed debt payments). A lender will likely include any existing debts in addition to the cost of any future loan you take on in your total debt service.
Here’s a small example. If you have $10,000 current and anticipated debt for the current year, but a forecasted net operating income of $15,000, your DSCR will be:
$15,000 / $10,000 = 1.5 DSCR
In this example, the business has more planned NOI coming in than total debt. If your DSCR equals 1, this means that you have just enough operating income coming in to meet your debt obligations, and a DSCR less than 1 means your business lacks the operating income to cover debt obligations.
Why Is the Debt-Service Coverage Ratio an Important Part of Any Business Loan Application?
The DSCR ratio may factor into your qualifications when applying for small business loans. Lenders use the DSCR formula to calculate whether or not a borrower has enough cash on hand to pay back what they owe, or whether they will in the future. The calculation takes into account your total net income and your annual debt payments — your principal payments (as well as interest) plus the costs of other forms of debt. It’s a good idea to figure out your DSCR before you apply for a loan so you know if you’ll qualify.
If a lender wants to get a full picture of the relationship between your personal and business income and debts, they may calculate what’s called a “global DSCR.” The global DSCR takes into account all available free cash flow and debt payments from the borrower and all guarantors, as well as the business. It can be calculated using the following formula:
Global DSCR = (net operating income + personal income) / (business debt service + personal debt service)
For some loans, personal income and personal debt service goes beyond just the proprietor and guarantors to include any related parties that may drain the cash reserves of the proprietor and the business.
What DSCR Are Banks Looking For?
Lenders generally want to see a DSCR of 1.25 or higher — meaning if you have a $1,000 in debt obligation, you’ll need $1,250 in net operating income to qualify for a loan.
A DSCR of less than one is a red flag for small business lenders. Where there are cases where a DSCR of less than one makes sense, these cases are few and far between, and a small business lender will generally rule out a business with calculated DSCR less than 1.
Why Do I Need to Know What My Business’s Debt-Service Coverage Ratio Is?
DSCR can’t paint a full picture of a business’s income and debt, but it is an important risk signal for lenders. Your DSCR tells lenders how likely you are to need to dip into cash reserves, or even default on your loan because of low operating income mixed with high debt. A company’s DSCR can determine whether or not the company is approved for financing, how much financing, and the rate and terms they are offered.
If you are denied a small business loan, small business lenders aren’t required by law to give you additional information about why your loan application was denied. This is different from personal loans, for which lenders are required to give more information. Calculating your DSCR before you apply for a business loan and knowing a lender’s requirements can save you time and money.
What Lenders Have the Most Liberal Debt-Service Coverage Ratio?
A debt-service coverage ratio is one way to analyze a company’s ability to repay its loan, but every lender has its own requirements. As mentioned, the minimum DSCR is typically 1, but many lenders want to see a slightly higher ratio than that. It would likely be difficult to qualify for a loan with a DSCR lower than 1. However, you’ll have to speak with potential lenders to understand their exact requirements to see if you qualify.
Ways to Improve Your DSCR
You need to prove that you have enough income to pay back your debt before many lenders are willing to let you borrow from them. If your debt service coverage ratio formula shows otherwise, you’ll want to make changes to your business model.
To increase your business’s DSCR, you can do any (or all) of the following:
- Increase your revenue. Your business’s income statement shows the annual net income you have made throughout the year. Bringing in more money to your business may improve your DSCR ratio.
- Decrease your debt. Whether it’s annual debt, short-term debt, or long-term debt, paying it down is a great way to improve your DSCR. By making larger loan payments to reduce your current loan amounts, you may appear to be less of a liability to loan officers.
- Lower your operating expenses. By reducing the operating expenses or payables on your balance sheet, you can increase your DSCR. You’ll have more cash on hand to cover your debts.
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This article was originally written on June 7, 2018 and updated on November 15, 2023.