January 2, 2020 | Last Updated on: July 21, 2022
A small business’s debt service coverage ratio, or DSCR, is an important financial ratio used to show the extent to which your business is able to cover its debt obligations. It seems fairly obvious, but it’s important for lenders, investors, and company executives to have a firm idea of whether that company can make payments on its loans.
DSCR is, predictably, a ratio. To perform a DSCR calculation, you’ll first need to calculate your company’s EBITDA – its earnings before interest, taxes, depreciation and amortization. You can find an EBITDA calculator here. Essentially, EBITDA measures the pure operating costs of a company. How much money it’s bringing in without considering anything related to debt or accounting.
Once you’ve calculated EBITDA, you divide that number by the company’s total debt service. That ratio is your DSCR.
Business A:
EBITDA – $400,000
Total Annual Debt Payments – $120,000
DSCR = 400,000 / 120,000 = 3.33
Business B:
EBITDA – $2,100,000
Total Annual Debt Payments – $850,000
DSCR = 2,100,000 / 850,000 = 2.47
There isn’t a particular set point where a bad debt service coverage ratio ends and a good one begins. There’s no minimum DSCR, and there’s no maximum. The higher the ratio, the better, though. The higher the DSCR is, the more cash flow leeway the company has after making its annual necessary debt payments. A DSCR over 1.0 means that the company’s net operating income is greater than its debt obligations, while a DSCR below 1.0 means that it isn’t making sufficient cash to cover its debt.
A company’s DSCR, like its EBITDA, total operating expenses, or any other signifier of a company’s financial performance, is an insightful and helpful way to track your company’s financial health overall. The factors that make the DSCR improve – an increase in net income, a decrease in current debt obligations – are factors are beneficial for the company in general. Working to improve a DSCR means working to improve your company as a whole.
But DSCR is also an effective way to calculate whether your company can take on additional debt. Many lenders take it fully into account while deciding whether to offer the company a loan (and at what terms).
Business C is looking to do some additional borrowing, seeking a short-term loan amount of $100,000. Their current EBITDA is $350,000 and their current annual debt payments total $230,000. Their current DSCR is 350,000/230,000, or 1.52.
But consider what Business C’s DSCR would be if they were approved for another hundred thousand dollars. Now their DSCR is 350,000 / 330,000, or 1.06 (for the sake of simplicity, assume Business C must repay its loan the same year).
For many lenders, a DSCR below a certain threshold become very risky. That number symbolizes what percentage of total debt a business is able to pay. For Business C, they’re only making 106% of their total debt load. Any sort of unexpected fluctuation in cash flow could lead to an inability to make payments in full and on time, which could very well lead to default on the bank loan or bankruptcy.
For any financial institution, lending money to a small business is effectively a bet on whether that company will be able to repay the loan at the agreed-upon interest rate. DSCR is, at its most simple, a number signifying the company’s ability to take on additional debt.
You never know when something could go awry with your business. A piece of equipment might break down and require repair or replacement. You may need to hire additional employees or move into a larger piece of real estate. By keeping abreast of your financial statements and frequently recalculating DSCR, you can stay ahead of the game. Because if and when an unexpected expense comes up, you want to make sure you have enough income to continue making the interest payments and lease payments you’ve kept up on while also accounting for new loan payments.
Because DSCR measures your net income against your debt, it can be a useful measuring stick for the financial health of your company. If you focus on improving DSCR, you’ll likely be making wise choices for your company’s financial future.
The only ways to improve a ratio is to grow the numerator or shrink the denominator. That means your EBITDA must increase or your total debt load must decrease.
Most business owners are already working to increase their earnings. That is, of course, the point of owning a business. But remember that there are other ways to increase net profits. For example, find ways to cut operating expenses. That might mean working with a more affordable product distributor or moving into a less expensive space.
Bear in mind, of course, that changing one piece of your operating expenses could also affect your company’s income. If your analysis suggests that hiring an additional salesperson will increase revenue by a greater number than the new person’s salary, then increasing operating expenses may actually improve your DSCR.
The other way to improve DSCR is to shrink the denominator – to decrease your debt payments. There are a few ways you can make improvements this way. If your business credit report is in good shape and you’ve been making regular payments, you may want to approach your existing lender or lenders about refinancing your existing loans. A lower interest rate means less money spent annually, which means a higher DSCR.
You could also take a more aggressive approach to paying down those existing debts. If your DSCR is already high, consider using some of that excess income to viciously attack the existing loans. Even though you’ll be spending additional money, you’ll be growing your DSCR, which will only serve to improve your chances for future loans, allowing your business to grow even further.
March 20, 2023
