Applying for small business loans can be stressful. But it wouldn’t be so bad if you knewÂ exactly what lenders are looking for, right? One of the biggest 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?
In this post, weâll cover everything you need to know about the debt service coverage ratio. Weâll teach you what a DSCR is, how to calculate your debt service coverage ratio, what a goodÂ DSCR looks like, how to increase your debt service coverage ratio, and more.
What Is The Debt Service Coverage Ratio?
The debt service coverage ratio (DSCR) measures the relationship between your business’s income and its debt. Your business’s 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 determine 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.
Why Is The Debt Service Coverage Ratio Important?
The debt service coverage ratio is important for two reasons:
- It shows how healthy your business’s cash flow is.
- It plays a factor in how likely your business is to qualify for a loan.
The debt service coverage ratio is a good way to monitor your business’s health and financial success. By calculating 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.
A high DSCR indicates that your business generates enough income to manage payments on a new loan and still make a profit. 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 need to increase your DSCR before taking on more debt.
In this way, knowing your DSCR can help you analyze your business’s current financial state and help you make an informed business decision before applying for a loan.
For lenders, the debt service coverage ratio is important as well. Your DSCR is one of the main indicators lenders look at when evaluating your loan application.
Lenders use the DSCR to see how likely you are to make your monthly loan payments. They also look at how much of an income cushion you have 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.
Here are some of the benefits of a high DSCR ratio:
- More likely to qualify for a loan
- More likely to receive an offer with better terms
- Increases your chances of lower interest rates and a higher borrowing amount
- Indicates your business can manage debt while still bringing in income
- Shows your business has a positive cash flow
Unlike your debt-to-income (DTI) ratio, which is healthiest when it is low, the higher your debt service coverage ratio, the better. It is not uncommon for lenders to ask for your debt service coverage ratio from previous years or for up to three years of projected debt service coverage ratios.
How To Calculate Your Debt Service Coverage Ratio
The debt service coverage ratio differs from the debt-to-income ratio in another significant way — lenders don’t all agree onÂ howÂ the DSCR should be calculated.
Different lenders have different ways of calculating your debt service coverage ratio. Some lump the business owner’s personal income in with the business’s income; others don’t. We’ll teach you the most common way to calculate DSCR, but be sure to check with your potential lender for the most accurate DSCR calculation.
Most often, the debt service coverage ratio is calculated by dividing your business’s net operating income by your current year’s debt obligations:
Net Operating Income / Current Year’s Debt Obligations = Debt Service Coverage Ratio
But what is net operating income and how do you determine your current year’s total debt?
Net Operating Income
Your net operating income is your total revenue or income generated from selling products or services, minus your operating expenses. According to the Houston Chronicle:
Operating expenses are those directly related to acquiring and selling your products and services. Such expenses might include costs to make or buy inventory, wages, utilities, rent, supplies and advertising. Operating expenses exclude interest payments to creditors, income taxes and losses from activities outside your main business.
Net operating income is also sometimes referred to as a business’s EBIT (earnings before interest and taxes). To calculate your net operating income, use accounting reports to find your annual income and average operating expenses.
Note: Some lenders calculate your debt service coverage using your EBITDA (earnings before interest, taxes, depreciation, and amortization) instead of your EBIT.
Current Year’s Debt ObligationsÂ
Your current year’s debt obligations refer to the total amount of debt payments you must repay in the upcoming year.
This includes all of your loan payments, interest payments, loan fees, business credit card payments, and any business lease payments. Tally up your monthly charges and multiply them by 12 to get your total year’s debt.
Now that you know how to figure your net operating income and total debt, let’s do an example using the DSCR formula from earlier:
Net Operating Income / Current Year’s Debt Obligations = Debt Service Coverage Ratio
Let’s say you’re calculating your debt service coverage ratio to see if you can take on a new small business loan to expand your business.
Say your business earns $65,000 in revenue annually but pays $15,000 in operating expenses. That leaves you with a net operating income of $50,000.
Now, let’s say each month you spend $2,000 on your mortgage, $400 on a previous loan, and $100 on your business credit card. That means you pay $2,500/mo on debt. Since the DSCR calculation requires the current year’s debt, we need to multiply our monthly debt by 12. That gives us a total of $30,000 in debt obligations for the year. Now, let’s plug these numbers in.
50,000 / 30,000 = Debt Service Coverage Ratio
50,000 / 30,000 = 1.666667
When you divide 50,000 by 30,000 you get 1.666667. Round this number to the nearest hundredth to get a current debt service coverage ratio of 1.67.
Now you’ve successfully calculated a debt service coverage ratio! Try plugging your own business’s numbers into the formula. And be sure to remember that this is onlyÂ one way of calculating your DSCR. While this way is fairly common, be sure to ask your lender how they calculate DSCR for the most accurate ratio.
What Is A Good Debt Service Coverage Ratio?
So now you know how to calculate your DSCR, but you may not know what makes a DSCR good or bad. How can you tell whether your debt service coverage ratio will qualify you to take out a new loan or if it means you’re in trouble?
When it comes to DSCR, the higher the ratio the better.Â Let’s say your DSCR is 1.67, like in our earlier example; that means you have 67% more income than you need to cover your current debts. If you have a DSCR ratio of 1, that means you have exactly enough income to pay your debts but aren’t making any extra profit. If your DSCR is below one, then you have a negative cash flow and can only partially cover your debts.
Obviously, you don’t want a negative cash flow, and breaking even doesn’t quite cut the mustard if you want to take out a loan. So what’s the ideal debt service coverage ratio that lenders look for?
In general, a good debt service coverage ratio is 1.25. Anything higher is an optimal DSCR.Â Lenders want to see that you can easily pay your debts while still generating enough income to cover any cash flow fluctuations. However, each lender has their own required debt service coverage ratio. Additionally, accepted debt service coverage ratios can vary depending on the economy. According to Fundera contributor, Rieva Lesonsky:
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, but in others — when the economy is tight — they may require a ratio of 1.35 or even 1.5.
FitSmallBusiness writer, Priyanka Prakash, notes that multiple aspects of your loan application can affect whether you are approved as well, not just your DSCR. Prakash says:
Your lender may be willing to overlook a slightly lower DSCR if other aspects of your application, such as business revenue and credit score, are very strong.
Be sure to carefully research each lender’s application process and qualification requirements before applying for a loan. Again, make sure you know how that specific lender calculates DSCR. This is important both for before you apply and after you are accepted as many lenders require you to maintain a certainÂ DSCR throughout the length of your loan.
Most lenders will reevaluate your DSCR each year, but you may want to check your debt service coverage ratio even more often to make sure you’re on track to meet your lender’s requirements. If you don’t meet their DSCR requirements, they may say you’re in violation of your loan agreement and expect you to pay the loan in full within a short time period.
To be safe, it’s always best to know exactly what your lender’s policies are and try to keep your DSCR as high as possible.
Using DSCR To Determine Whether You Can Afford A Loan
Not only can you use your DSCR to check your business’s financial health and ability to pay its debt, you can also use it to determine if you can afford a loan and how big of a loan you should take out.
Let’s return to our example from earlier. Your business is trying to decide if it can afford to take out a business expansion loan. We calculated your current DSCR at 1.67, which means you have an extra 67% of income after you’ve paid your debts. This is well above the 1.25 DSCR mark, but it doesn’t necessarily indicate the size of the loan you can reasonably afford to borrow.
Take your annual income and divide it by 1.25 to figure out how much you can afford to pay back each year:
Net Operating Income / 1.25 = Borrowing Amount
50,000 / 1.25 = 40,000
In our example, your current year’s debt obligations were $30,000/year. From the calculation above, we can see that you can afford to pay up to $40,000 a year on your debt obligations. So, you can take on an extra $10,000/year in debt (because $40,000 – $30,000 = $10,000). That amounts to roughly $830/mo.
If you approach a potential lender knowing exactly how much you can afford to pay each month, you can avoid being pressured into borrowing more than you can afford.
If you aren’t comfortable with a 1.25 DSCR and would rather have a little more wiggle room, that’s totally fine. Don’t ever borrow more than you are comfortable with. The good thing is, you can use the debt service coverage ratio to see exactly how much you can safely borrow while maintaining your desired DSCR. Simply replace “1.25” in the formula above with your desired ratio to figure the payments you can afford.
How To Improve Your Debt Service Coverage Ratio
To increase your chances of getting a loan — or to maintain payments on your existing loan — you may need to improve your DSCR. Here are a few ways to increase your debt service coverage ratio:
- Increase your net operating income
- Decrease your operating expenses
- Pay off some of your existing debt
- Decrease your borrowing amount
To increase your net operating income, consider various ways to increase your revenue. Maybe offer additional services or goods or raise your prices. Try a new marketing strategy that brings in additional buyers or offer an extra incentive to existing buyers to make them purchase more goods.
Increasing sales isn’t the only way to increase your net operating income. A huge portion of your net operating income comes down to operating expenses. Cut back unnecessary expenses. Find ways to streamline your work processes and make employees more productive during work hours. Ask your existing vendors about discounts for buying in bulk. Maybe even consider eliminating products that don’t sell well or are too time-consuming and expensive to make.
Besides increasing your net operating income, a good way to lower your debt service coverage ratio is to lower your existing debt.Â Carefully evaluate your budget. Cut unnecessary expenses and allocate that money to paying down your debt instead. You can pay off your debt quickly using various methods like theÂ debt snowball methodÂ or theÂ debt avalanche method. Depending on your financial situation,Â consolidating your business debtÂ might also be a good option.
For small business searching for funding, the debt service coverage ratio plays a huge factor in lending decisions. Lenders use your DSCR to determine whether you can afford to make regular loan payments and how much you can borrow.
But more than that, your debt service ratio is also a great tool for understanding your business’s financial health and cash flow. Your DSCR can show you both how much income your company has after debt payments and whether it’s financially wise to take out a loan. The higher your DSCR, the better.
As always, we recommend carefully evaluating your financial situation before seeking a loan. Calculate your DSCR, see if you can afford to take on a loan, and know exactly how you are going to use that loan before you borrow. With debt service coverage ratios, it’s more important than ever to carefully research your lender’s requirements as each has their own way of calculating the DSCR. And don’t forget to confirm whether your lender requires you to maintain a specific DSCR for the length of the loan.
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