Why Your Debt Service Coverage Ratio Could be Holding You Back
May 16, 2019 | Last Updated on: April 3, 2023
May 16, 2019 | Last Updated on: April 3, 2023
Your company’s Debt Service Coverage Ratio (DSCR) is an important metric, like your business credit score, that financial institutions can use to determine whether to offer your business a new loan. While it’s a very important number for your company and any lenders considering a business loan, many business owners aren’t aware of how it works. It’s actually very simple to calculate your DSCR. In this article, we’ll explain exactly what your company’s Debt Service Coverage Ratio means, how it’s used by financing companies to evaluate your business, and how you should use it to keep yourself and your business in tip-top financial shape.
Your DSCR shows potential lenders whether or not your business is generating enough money to pay the debts you currently hold – and whether it’d be smart for them to offer you an additional loan. DSCR has three kinds of levels: below 1, approximately 1 and above 1. A DSCR above 1, such as the 1.25 calculated in the example below, means that your business is generating more money than you’re losing in debt payments. This is good news. Because you’re able to make your current payments with room to spare, lenders will be more likely to offer your company a loan. A DSCR at or around 1 means that you’re just about breaking even. For now, you’re able to cover the required payments, but any interruption to cash flow could lead to a DSCR below 1, which you’ll want to avoid. If your DSCR is below 1, it means your company is not generating enough money to cover your current loan payments. If this is the case for your business, you may find it hard to acquire new funding. Rates will be higher and some lenders will turn you down altogether until you can show that you have enough cash flow to cover your company’s debts.
First, you need to add up your EBITDA: your earnings before interest, tax, depreciation, and amortization. So you’ll take your net income, and then add back any interest payments, taxes, and amortization. That total forms the numerator of your DSCR. Then, in the denominator, you’ll insert the total of all debt payment you make over the course of the year. It’s that simple. For example, say your EBITDA for a given year is $150,000 and you’ll pay a total of $120,000 on various debts. That makes your DSCR = 150,000/120,000 or 1.25. Your DSCR shows potential lenders whether or not your business is generating enough money to pay the debts you currently hold – and whether it’d be savvy for them to offer you an additional loan. A DSCR above 1, such as the 1.25 calculated in the example above, means that your business is generating more money than you’re losing in debt payments. This is good news. Because you’re able to make your current payments with room to spare, lenders will be more likely to offer a loan. A DSCR at or around 1 means that you’re just about breaking even. For now, you’re able to cover the required payments, but any interruption to cash flow could lead you to a DSCR below 1, which you’ll want to avoid. If your DSCR is below 1, it means your company is not generating enough money to cover your current loan payments. If this is the case for your business, you may find it hard to acquire new funding.
Like the answer to so many questions in the business world, it depends heavily on your business’s specific context. But thankfully there are some clear rules of thumb you can follow. Lenders obviously and reasonably prefer a debt service coverage ratio well above 1. For the most part, it will probably prove difficult to secure a new loan with a DSCR below 1.15. That makes sense: for all intents and purposes, a business loan is a bet on your company, and if your company is generating more money than it sends out, your company is a safer bet than a company that’s only breaking even, or worse. But there are mitigating factors even when a company’s DSCR doesn’t look that good. If you or your business hold lots of collateral, offering lenders that collateral could lead to leniency when it comes to a DSCR. You could also show a willingness to personally fund your business to cover any gaps between income and outgoing debt payments. Some financial institutions will also see a high personal or business credit score as a mitigating factor against a low DSCR. If you’ve shown an ability to make payments and display a responsible credit history, lenders may overlook a less-than-stellar DSCR. Remember, too, that not all loans will induce lenders to examine your debt service coverage ratio. That examination is very common for larger loans, but those underwriting smaller loans may not take DSCR into account. Finally, context matters to the lender as well. If the economy is doing particularly well, lenders will be perfectly comfortable lending money to companies with DSCRs below 1.2. In tighter times, the threshold number could rise closer to 1.35 or more.
Business owners use their knowledge of debt service coverage ratios in a few important ways. The first use is when creating a business plan. While your planning and inferences about the future aren’t likely to be exactly accurate, you should calculate your projected DSCR for at least two or three years in the future based on current revenue streams and debts. Having those projections complete in a realistic and objective manner can help you figure out the best possible times to seek new funding so you can jump on them quickly, or know when it’s time to tighten the belt. Secondly, DSCRs are useful metrics for a business owner looking at acquiring another company. Seeing the new business’s DSCR can help the acquiring owner decide whether the new business can improve existing revenues, or whether the new company will cost money in the long term in addition to the cost of acquisition. Finally, your DSCR is a helpful snapshot of your company’s financial health. Frequently, calculating and tracking the ratio is a helpful way to maintain an understanding of where and when your business is succeeding or faltering.
To improve your debt service coverage ratio, you have two options: make the numerator bigger or the denominator smaller. Obviously, paying off a debt will improve your DSCR. But you could also consider if refinancing an existing debt could save interest payments, which could improve your debt service coverage ratio. One other option is to increase revenue. You could try to increase prices, negotiate for more or more lucrative work, expand into a new market, or focus on improving your company’s marketing. You could also consider cutting costs. Can you maintain the necessary inventory with a less expensive supplier? Can you move into a smaller or less expensive space? Have you hired too many people? A combination of decreasing debt payments, increasing revenue, and reducing costs can add up to an impressive improvement in DSCR, which can lead to a better chance at further funding, which is an important step in building your business.