Calculating Your Debt Service Coverage Ratio
March 9, 2019
March 9, 2019
What is a¬†Debt Service Coverage Ratio? Why is it important?
You‚Äôve probably heard the term¬†Debt Service Coverage Ratio¬†(DSCR) if you‚Äôre applying for a commercial loan. Your¬†debt service coverage ratio¬†compares your business‚Äôs¬†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‚Äôs¬†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‚Äôs 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‚Äôs¬†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‚Äôs¬†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.
For example, let‚Äôs 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¬†‚Äď such as insurance, utilities, repairs/maintenance, property taxes, property management fees, taxes, and¬†depreciation¬†on this property ‚Äďtotal $400,000. The straightforward calculation of $500,000 – $400,000 shows your property‚Äôs¬†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‚Äôs 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‚Äôs¬†total debt service.
Let‚Äôs 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.
Interest payments: $40,000
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 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:
And, going forward, continue to monitor your¬†DSCR¬†‚Äď even when you are not looking to acquire funds. Every month, check on any aspect of your business‚Äôs finances that you can adjust. The¬†financial health¬†of your business depends on it.