Debt Service Coverage Ratio: How To Calculate & Improve Your Business’s DSCR

If you’re applying for a small business loan, one of the biggest factors lenders will consider is your small business’s debt service coverage ratio (DSCR). But, what is a DSCR? How can you figure out what yours is?

Read on to learn everything you need to know about the DSCR, how to calculate it, and how you can improve yours.

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.

Why Is The Debt Service Coverage Ratio Important?

The DSCR 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 you 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 DSCR, the better. It is not uncommon for lenders to ask for your DSCR from previous years or for up to three years of projected DSCRs.

How To Calculate Your Debt Service Coverage Ratio

The DSCR differs from the DTI ratio in another significant way; lenders don’t all agree on how the DSCR should be calculated.

Different lenders have different ways of calculating your DSCR. 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, DSCR 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?

What Is A Good Debt Service Coverage Ratio?

When it comes to DSCR, the higher the ratio, the better.

Let’s say your DSCR is 1.67, per 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.

In general, a good debt service coverage ratio is 1.25. Anything higher is an optimal DSCR. 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.

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 before you apply and after you are accepted, as many lenders require you to maintain a certain DSCR throughout the length of your loan.

Most lenders will reevaluate your DSCR each year, but you may want to check yours 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 per 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 per year in debt (because $40,000 – $30,000 = $10,000). That amounts to roughly $830 per month.

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 DSCR to see exactly how much you can safely borrow while maintaining your desired DSCR. Replace “1.25” in the formula above with your desired ratio to figure out 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

Check out our article on improving your debt service coverage ratio to learn more about the methods listed above.

Final Thoughts On DSCR

For small businesses 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.

We have articles that can help you decide how much of a business loan you can get, reviews of our favorite small business loans, and explanations of other important factors potential lenders will consider, like your personal debt-to-income (DTI) ratio.