What is a Debt Service Coverage Ratio? Why is it important?
You’ve probably heard the term Debt Service Coverage Ratio (DSCR) if you’re applying for a commercial loan. Your debt service coverage ratio compares your business’s annual net income against your existing and proposed annual debts. This ratio helps lenders judge your ability to repay a loan, considering your income and expenses. Lenders are always looking to decrease the risk of loan repayment. Business loan underwriters will often use debt service calculators to measure this ratio when they analyze a borrowers business.
The range of a Debt Service Coverage Ratio is usually between 0.00 and 2.00. If your business has a ratio of 1.00, your company’s net income is exactly sufficient to repay your debts. If your ratio is 1.20, it means your company makes 20% more than needed to pay your debts. And if your ratio is 0.90, it means your company makes only 90% of what it needs to repay debts. Each lender has a minimum requirement that your business must meet to qualify for a loan. Most lenders require a minimum of 1.20 DSCR. This number shows that your business has a meaningful cushion available should any financial hardships occur.
For the lender, DSCR is a straightforward calculation.
Debt Service Coverage Ratio = EBITDA/Total Debt Service
Seems pretty simple right? It is when you break it down.
Let’s look at the first part of the formula. The term EBITDA stands for Earnings Before Interest, Taxes, Depreciation, and Amortization. EBITDA is used to analyze and compare the profitability of companies and industries without the effect of accounting and financing activities. EBITDA is your company’s annual Net Operating Income (NOI) adding back in interest, taxes, depreciation, and amortization. That is, NOI is income after reasonable operating expenses are deducted. While this number can change over time based on income and expenses, EBITDA is the most reliable way to assess an organization’s financial health. Lenders find EBITDA to be the truest measure because this metric is least susceptible to manipulation, while still including key non-operational expenses.
An Example of How to Calculate Debt Service Coverage Ratio
For example, let’s say you have an income property. Your total yearly revenue from rents, parking, and service fees is $500,000. Of course, this number takes into consideration potential vacancies or credit loss. The reasonable operating expenses – such as insurance, utilities, repairs/maintenance, property taxes, property management fees, taxes, and depreciation on this property –total $400,000. The straightforward calculation of $500,000 – $400,000 shows your property’s annual net income to be $100,000.
To calculate the annual Net Operating Income/EBITDA, we add back in the non-operational expenses: interest payments $40,000, taxes $80,000, depreciation $20,000, and amortization $10,000. And we get an annual Net Operating Income/EBITDA of $250,000.Now let’s look at the second part of the formula. Total Debt Service is the amount of money required to pay both the principal and interest on a debt for a specific amount of time. To figure out Total Debt Service, first, a business owner establishes how much money they need to borrow. Then they add the interest and term of the loan to calculate the annual debt payment. And then finally they add to that amount any existing loans and their interest. This is the business’s total debt service.
Let’s go back to your example investment property. Say you decide you need to make improvements to your property and so you would like to start investigating your business loan options.
Yearly revenue: $500,000
Interest payments: $40,000
Annual net income: $100,000
Interest payments: $40,000
Total debt service:
Business loan amount: $220,000
Annual Interest Rate: 20%
Term of Loan: 2 years
Annual debt payment including interest: $132,000
Debt Service Coverage Ratio = $250,000/$132,000= 1.89
Using this example, your company has a DSCR of 1.89. A DSCR of 1.89 tells a lender that your business has the yearly cash flow to cover 189% of your yearly loan payments. As stated earlier, most lenders require a DSCR of 1.20. But keep in mind that all lenders have their own sets of requirements. Certain lenders may require DSCRs from previous years as well as projected DSCRs. And occasionally, loan terms may require businesses to maintain a DSCR threshold of 1.00-1.05. This threshold condition requires a minimum DSCR to be maintained at the end of any calendar quarter through the life of the loan. If the minimum threshold is not maintained at the end of any calendar quarter, the loan contract could become void. This could lead to immediate repayment demands from the lender.
In certain cases, a lender must look at your monthly DSCR. This would apply to businesses that have been in business for less than a year, or those applying for a short-term loan. Monthly DSCR will give a lender a more accurate view of your finances. Monthly DSCR follows the same formula as annual DSCR.
What if you have a bad DSCR?
What should you do if you find yourself in the position of a less than desirable DSCR when your business needs a loan? Here are a few areas for you to investigate:
- Can you increase your business revenue?. And while that may sound impossible, first see whether there are any costs you can cut. Consider speaking with your landlord to decrease rent, or look into alternate, less expensive staffing plans.
- Can you increase the cost of your service? If you own commercial property, could you increase your tenant’s rent? Or if you sell a product or service, could you increase the price? Are there any contracts that you can renegotiate?
- Are your finances correct? Review your records with your accountant. Are there any errors in your expenses or records?
- Can you pay off a debt?. If you can and you do, you will be decreasing your total debt service. As you saw above, that will lead to a higher DSCR.
And, going forward, continue to monitor your DSCR – even when you are not looking to acquire funds. Every month, check on any aspect of your business’s finances that you can adjust. The financial health of your business depends on it.
For further information on DSCR, check out this helpful guide that was put together by Biz2Credit that goes into all of the different aspects pertaining to Debt Service Coverage Ratio.