Calculating Your Debt Service Coverage Ratio

When applying for a small business loan, you’ve probably heard the terms “debt service coverage ratio” and “debt to income ratio.” It’s helpful for you as a small business owner to understand what these terms mean in relation to your business’s ability to cover its debts. It’ll help to know what lenders look for when evaluating your business, whether for getting an unsecured loan, commercial real estate loan, or other small business loan.

What is Debt Service Coverage Ratio (DSCR)?

The Debt Service Coverage Ratio (DSCR) is a metric many lenders use to determine a small business owner’s creditworthiness and ability to meet its debt obligations. 

DSCR loans are often used by real estate investors who want to qualify for a loan based on their investment properties’ cash flow instead of having to provide proof of income. The debt service coverage ratio can also be used for qualifying a borrower when they apply for an unsecured loan and other types of loans when a lender wants a more comprehensive view of a borrower’s business. 

Debt Service Coverage Ratio: What’s Good and How to Calculate It

To calculate your business’s DSCR, you first need to determine its EBITDA, or earnings before interest, taxes, depreciation, and amortization.

Next, figure out your business’s current monthly debt obligations plus any that may be added, such as a loan you’re taking out. Your monthly debt payments include real estate loan payments, equipment financing payments, business auto payments, and business lines of credit payments. Then multiply your total monthly debt payments by 12 to determine your annual debt obligation. 

Next, divide your EBITDA by your annual debt obligation to calculate your debt service coverage ratio. For example, if your EBITDA is $200,000 and your annual debt obligation is $170,000, the formula is $200,000 ÷ $170,000 = 1.18.

A simpler way to calculate your business’s DSCR is to take your company’s net operating income and divide it by its debt service. Net operating income is a business’s pre-tax gross income minus operating expenses over a set period. Debt service is how much cash is needed to pay a loan’s principal and interest over a given period.

For example, if your net operating income is $500,000 and your debt service is $100,000, $500,000 ÷ $100,000 = 5.

What’s A Good DSCR?

While there’s no universally agreed upon DSCR, the higher the number, the better. A DSCR of less than 1 is typically unacceptable to lenders because it means the business’s cash flow wouldn’t be able to meet its debt obligations. A higher DSCR typically means a business has enough net operating income to pay its monthly debts.

In the previous examples, 5 is an excellent DSCR, while 1.18 is cutting it close to the minimum requirement.

The debt service coverage ratio is rarely used alone in the small business loan underwriting process. Loan providers also consider how long you’ve been in business, your personal and business credit scores, and other important business metrics such as your debt-to-income ratio.

What is the Debt to Income Ratio (DTI)?

The debt-to-income ratio is another measurement lenders consider to determine a borrower’s ability to repay a small business loan, particularly when evaluating unsecured loan applications. It compares your business’s monthly debt obligations to its monthly income and evaluates how much more debt you can take on.

The DTI calculation takes the total of your monthly debt payments and divides it by your business’s gross monthly income.

The threshold of what qualifies as a good DTI ratio varies by lenders, but generally, 35% or less is considered good, while anything over 50% is unacceptable. While debt service coverage ratios are better when they’re higher, the opposite is true of debt-to-income ratios. A lower DTI ratio is better because it increases confidence with lenders that you can take on additional debt and pay off the loan. On the other hand, a higher DTI ratio means your business would struggle with more debt.

However, lenders look at many other factors in addition to the DTI ratio to determine your eligibility for a new business loan.

These factors include:

• how much down payment you can offer
• your credit score, credit history, and credit utilization
• the general financial health of your business
• equity you might have in your commercial mortgage loan or personal home equity

Ways to Increase Your Debt Service Coverage Ratio

Small business owners who’ve received loans with higher interest rates or are turned down altogether often wonder if there’s a way to increase their debt service coverage ratio.

Here are a few ways to raise your DSCR.

Consider refinancing current loans

If you have existing loans, explore refinancing options that might lower the interest rates or offer longer repayment periods to reduce your monthly payments. If you have a commercial real estate loan, consider renegotiating with your mortgage lender for a lower interest rate or refinancing to reduce your mortgage payments. This can reduce your monthly expenses and possibly raise your DSCR.

Renegotiate terms on your current obligations

Ask your current vendors if they can give you lower prices on supplies or inventory or offer better terms. If not, look into other vendors willing to negotiate more favorable terms. You can also get a balance transfer on high-interest business credit cards and move your credit card balances to a lower-interest credit card to reduce your credit card payments. These things can help lower your net operating expenses and potentially increase your DSCR.

Pay off existing debt or business loans

If you can pay off any current debt, do so. The less debt burden you can show a lender, the better. This is a feasible idea if you have a smaller loan and you’re considering financing a much bigger one. A commercial auto loan is also fairly easy for many small business owners to pay off. Some business owners will even pull from their personal savings or other assets if it means facilitating the growth of their business and getting a business loan at a lower interest rate.

Consider debt consolidation

Consolidating some of your business debt into a smaller, more manageable payment can free up some of your cash flow, making it easier to take on more debt to grow your business. The terms of a debt consolidation loan would have to be right to make it worth your while, but you can run the numbers and talk with a financial expert to determine if it makes sense for your business.

Partner with a small business financing expert

There are many moving parts in small business financing. Debt service coverage ratios are just part of the equation. A business financing expert or small business loan broker can evaluate your business and financial statements to identify how to boost its gross and net operating incomes and lower any operational expenses. This can help improve your DSCR for better business loans and increase the financial stability of your business.

FAQs about Debt Service Coverage Ratios

What is a good debt-to-income ratio?

A DTI ratio of 36% or less is preferred, although some small business loan providers may find a DTI ratio of up to 50% acceptable.

Is 1 an acceptable debt service coverage ratio?

A DSCR of 1 falls right on the minimum accepted ratio by some lenders, but may vary depending on the lender. Most lenders prefer a higher DSCR of at least 1.25 to 1.50. A DSCR of 2 or higher is considered strong and typically means a business is financially more prepared to take on additional debt.

How does the debt-to-income ratio impact a business loan?

A lower DTI ratio will make it easier to qualify for a business loan with a more favorable interest rate. With a high DTI ratio, you may not qualify for a new loan or if you do, the interest rate will likely increase.

How is the debt-to-income ratio calculated for a business loan?

Lenders often use a simple formula that divides your business’s monthly debt payments by its gross monthly income.

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