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What Is Debt-Service Coverage Ratio?

Brent Wiblin, Senior Managing Director, First Republic Bank
November 17, 2021

The debt-service coverage ratio, commonly abbreviated as DSCR, is an important term for small business owners and individuals alike to know. The debt-service coverage ratio refers to the ability of a person, business or governmental entity to cover its debts. At a high level, the ratio measures a party’s available cash flow to repay the sum of its debt obligations, thereby telling an important story about an entity’s level of risk.

While the debt-service coverage ratio can be — and often is — applied at an individual level in some capacity, it’s most commonly referenced in the world of business. In particular, small business owners need to know if they’re able to cover their debts with their existing cash flow. The debt-service coverage ratio helps business owners know this — and helps lenders do the same.

Understanding the debt-service coverage ratio is a crucial part of securing credit as a small business. You need to know how to calculate your debt-service coverage ratio and what your ratio means in terms of your business and future opportunities for financing.

Debt-service coverage ratio definition

A business’s debt-service coverage ratio (DSCR ratio) is the ratio of the party’s net operating income (NOI) to that party’s debt service (which encompasses all applicable interest, principal and lease payments).

Debt-service coverage ratio calculations include your net operating income: business revenues minus your operating expenses, without interest payments, depreciation and amortization (this is similar to earnings before interest, taxes and depreciation, or EBITDA).

DSCR calculations should encompass all debt obligations, including:

●  Loans

●  Line of credit payments

●  Lease payments

Debt-service coverage ratio calculations must take into account both the principal and interest of your debts.

Why is your debt-service coverage ratio important?

The debt-service coverage ratio may not be discussed as much as, say, revenues, but it’s an important number to know. For businesses specifically, a debt-service coverage ratio is a fundamental tool business lenders use to vet prospective borrowers: it demonstrates a potential borrower’s ability to repay a loan. 

Along with revenues and credit scores, lenders look critically at a business’s debt-service coverage ratio. Business lenders virtually always require borrowers to have a debt-service coverage ratio higher than 1.00 (the minimum is typically closer to 1.25 — more on this below). This translates to a business being able to pay 100% of its debt payments at its current operating level and at the 1.25 level, with some cushion.

An entity with a lower DSCR is generally considered a higher risk, more likely to default on its debts. Conversely, an entity with a high DSCR is generally viewed as a more favorable candidate with less risk of loan default.

A debt-service coverage ratio of higher than 1.00 indicates the borrower can still pay their debts, even if their income dips slightly. On the other hand, a debt-service coverage ratio below 1.00 can raise red flags for a lender, since this ratio suggests the borrower lacks the cash to cover all of its debts — and may ultimately default on a loan. Therefore, a candidate with this lower ratio can be riskier and is unlikely to be approved for loans or and other forms of credit. A debt-service coverage ratio of 1.25 translates to a business being able to repay 100% of its debts at its current operating level.

The debt-service coverage ratio provides another insight into your business’s financial health, which is always helpful. However, it’s also important to understand and keep track of your business’s debt-service coverage ratio, since it generally plays a crucial role in your company's ability to secure business financing, such as business lines of credit and other credit instruments.

How do you calculate your debt-service coverage ratio?

Calculating your debt-service coverage ratio is relatively straightforward: you simply need to use the debt-service coverage ratio formula.

DSCR = Annual Net Operating Income / Annual Debt Service

Net Operating Income: Gross income minus operating expenses

Debt Service: The sum of all current debts

A debt-service coverage ratio is typically displayed as a decimal. For example, a business that has a net operating income of $250,000 and a debt service of $200,000 has a debt-service coverage ratio of 1.25. Looking at it another way, this hypothetical business can pay 125% of its debts under its current operating circumstances, leaving it some wiggle room in case conditions change.

Let’s look at the numbers in reverse. A business with a net operating income of $200,000 and a debt service of $250,000 has a total debt-service coverage ratio of 0.80, which is far below the minimum standard of 1.00. In other words, this business can only pay for 80% of its debts as it currently operates, which may flag it to lenders as a risk for default.

As discussed, lenders generally look at a debt-service coverage ratio of 1.25 as favorable, since this decimal indicates a lower-risk borrower.

What’s a good debt-service coverage ratio?

A business’s debt-service coverage ratio is one of the most important numbers a lender looks at when deciding whether to approve a small business loan.

Most banks set strict debt-service coverage standards; they typically seek borrowers with a debt-service coverage ratio of at least 1.25. It’s worth noting, however, that this number depends on a variety of factors, including the current economic conditions, the industry in which the business operates as well as a given bank or lender’s specific requirements. For example, the U.S. Small Business Administration (SBA) currently requires a DSCR of at least 1.15 for SBA loan approval.

Current economic conditions matter because when the economy is in poor shape, minimum debt-service coverage ratio requirements generally rise; in more favorable periods, when the economy is healthy and thriving, a given lender’s debt-service coverage ratio requirement may drop.

Knowledge is power

If you’re a small business seeking financing, or want to position yourself to do so in the future, your debt-service coverage ratio is as important as any other financial metric. This is also the case for individuals looking to secure financing on a personal level. Lenders strongly take into account a party’s debt-service coverage ratio when assessing a candidate’s risk and deciding whether they would be a favorable candidate for loan approval.

Beyond simply looking at debt-service coverage ratio in terms of securing financing, you may find it helpful to know your debt-service coverage ratio as a general business metric. Grasping this financial concept may make it much easier to understand your ability to address your financial obligations, and ultimately help you manage your finances wisely.

 

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