Financial ratios are particularly important for small business owners who seek out financing to grow their business. These ratios help business owners measure the profitability and overall health of a business. The term Debt-Service Coverage Ratio (DSCR), also known as Debt Coverage Ratio (DCR), is used in various financial contexts.
In the small business context, DSCR indicates the cash ratio a business has on hand for servicing its pre-existing debt. Specifically, the debt includes payments on leases, principal, and interest.
The Importance of Debt-Service Coverage Ratios
DSCR is one of the numerous financial ratios that lenders use to asses whether to approve a loan application from a small business. A significant consideration of a lender is whether a small business has the ability to pay back a loan. It is particularly important for lenders to determine whether a business will continue to generate enough revenue to pay back the principal with interest over the full term of the loan.
Lenders typically want to see some amount of cash flow above the minimum threshold needed to pay back the loan with interest. If your small business can barely generate enough income to cover the cost of the loan, most loan officers would consider this a sign your business is not performing well enough to take out a loan.
All lenders have a minimum DSCR requirement that is required for approving a small business loan. Typically, the ratio needs to be above 1.25. However, this minimum ratio can fluctuate with the state of the overall economy. For instance, if the economy is doing well, lenders might lower their minimum ratios to 1.15. However, if the economy is struggling, they might raise the minimum ratio as high as 1.5. Overall, the higher your ratio, the better your prospects are for securing a business loan, regardless of the state of the economy.
Calculating Your Business’s Debt-Service Coverage Ratio
Before approaching a lender for a small business loan, it is important that you calculate your business’s current DSCR and take remedial steps to improve it if necessary. In general, it is a good practice to present prospective lenders with a DSCR for three upcoming years and the preceding three years.
Two methods are commonly used for calculating DSCR. In essence, the ratio is calculated by dividing your total annual net operating income by your total annual debt service. When using these formulas, you should take the final figure out to the second decimal point.
|First Method||Second Method|
[(Annual Net Operating Income + Other Non-Cash Charges and Depreciation) / (Current Maturities of Long-Term Debt + Interest) = DSCR]
[(Earnings Before Interest, Taxes, Depreciation and Amortization) / (Current Maturities of Long-Term Debt + Interest) = DSCR]
Examples of Debt-Service Coverage Ratios
For an example of calculating DSCR, let’s say your business’s total net operating income is $200,000 and you are applying for a small business loan which costs $125,000 annually to service the debt. In this instance, your DSCR would be 1.60 [$200,000 / $125,000]. Most lenders would likely approve the $125,000 based on a 1.60 DSCR.
However, if your business has existing debt service before applying for the loan, you will need to figure this in with the cost to service the new loan.
If for example, your net operating income is $200,000, you currently have $50,000 of existing debt service, and are applying for a loan which costs $125,000 to service annually, your DSCR will be 1.14 [($200,000 / ($50,000 + $125,000)]. In this case, lenders would likely say your business is over-extended with debt and would not approve the $125,000 loan.
Debt-Service Coverage Ratio Monitor
Overall, maintaining a healthy DSCR is crucial to securing a new loan and preventing a pre-existing loan from being called early. In general, a provision of any loan agreement will stipulate that your business agrees to maintain an adequate DSCR for the entirety of the loan period. If your DSCR falls below this agreed-upon threshold, the lender reserves the right to call the loan early and demand payment in full.
Thus, it is important that you take steps now to protect your DSCR for current and future loans. With adequate monitoring and maintenance, your business stands a better chance of acquiring and retaining business financing to optimally grow your company.