DSCR Explained for Small Business Owners
March 4, 2022
March 4, 2022
In this article, youâ€™ll learn:
According to the Biz2Credit Small Business Lending Index, loan approval percentages at big banks, small banks, institutional lenders, alternative lenders, and credit unions are still roughly half of what they were in January 2020. In many cases, lenders deny borrowersâ€™ small business loan applications because they donâ€™t meet quantitative metrics â€“ one of these metrics is the debt service coverage ratio.
Debt service coverage ratio (DSCR) is a number that shows whether a company has enough cash flow to pay its current debt obligations.
To calculate your DSCR, start by figuring out your EBITDA, which is your earnings before interest, tax, depreciation, and amortization. Next, add up your current debt obligations. Lastly, divide your EBITDA by your current debt obligations.
Say you have EBITDA of $300,000 and current debt obligations are a total of $250,000. In this case, your DSCR calculation would be 300,000/250,000 = 1.2.
Hereâ€™s a debt service coverage ratio calculator to save you some time.
A debt service coverage ratio of one or higher indicates that a company has enough income to satisfy its current debt obligations. A DSCR of below one, on the other hand, shows that your company canâ€™t cover all of its debt payments.
So, does that all mean that lenders are happy with a DSCR of one or higher?
There are no guarantees in the business world, so lenders want to protect themselves against fluctuating EBITDA. For example, a lender might not want to approve a small business loan that would leave a borrower with $150,000 in EBITDA and $150,000 in current debt obligations, as any decrease in EBITDA could prevent them from making the monthly payments.
The minimum DSCR depends on the lender, industry, and company outlook, but a DSCR of 1.2 is a common requirement for borrowers seeking small business loans.
To improve your DSCR, you need to either increase your EBITDA or decrease your debt obligations.
Letâ€™s look at how you can accomplish each of those objectives.
Your EBITDA is a good indicator of your business performance, as it removes some extraneous factors that impact a companyâ€™s bottom line number. As such, the metric is commonly used by lenders to determine a companyâ€™s ability to satisfy debt obligations.
As a small business owner, youâ€™re always looking for ways to increase your earnings. Here are a few possibilities to consider:
There are more paths to higher earnings than to lower debt obligations, but itâ€™s far from impossible to reduce your debt. Here are a few options:
Try to Increase Your EBITDA and Decrease Your Debt Obligations
Since there are no guarantees in the business world, you should try to increase your EBITDA and decrease your debt obligations for best results. By doing this, you can increase your DSCR even if some of your strategies arenâ€™t successful. And if you are successful in both objectives? Youâ€™re going to have an outstanding DSCR, making it much easier for you to qualify for small business financing with attractive terms.
How to Overcome a Relatively Low DSCR
The strategies to improve your DSCR take time to show results. So, how do you get a loan if you have a relatively low DSCRâ€¦ and no time to increase earnings or reduce debt?
Letâ€™s look at a few options:
Does your business have valuable equipment or real estate? If so, you may be able to offer them to lenders as collateral. By doing this, you can alleviate a lenderâ€™s concerns about what would happen if you fail to make your monthly debt payments.
This option should be carefully considered, as it means putting your personal assets at risk. But if you are only able to get a loan with really unfavorable terms or you arenâ€™t able to get any type of loan, you should at least explore this possibility. You should only provide a personal guarantee if you are extremely confident in your companyâ€™s ability to make monthly repayments. Itâ€™s best to talk to a CPA before moving forward with this option.
Do you have a high credit score? If so, a lender may be willing to overlook a relatively low DSCR â€“ assuming it is one or higher. From the lenderâ€™s point of view, a solid credit history indicates that the borrower knows how much debt can be handled by the business.
Global debt service coverage ratio (DSCR) is based on business income and business debt, as well as personal income and personal debt. So, global DSCR is a broader metric than the standard DSCR formula.
For small business owners who have a strong personal balance sheet, it may make sense to leverage their global DSCR to qualify for a small business loan. On the other hand, a small business owner with a weak personal balance sheet may struggle to get approved for a business loan if global DSCR is taken into the equation.
As an entrepreneur, your DSCR is one of the most important metrics for your small business. By understanding how to calculate your DSCR and how to improve your DSCR, you are better positioned to get a new loan with favorable terms.
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