- Debt service coverage ratio measures a business’s cash flow versus its debt obligations.
- DSCR can help businesses understand whether they have enough net operating income to pay back loans.
- To calculate DSCR, divide net operating income by debt service, including principal and interest.
For small businesses to holistically understand their finances, it’s important to understand how to calculate debt service coverage ratio (DSCR), which can help a business decide how much it can afford to pay in debt obligations. The DSCR is a measure of a business’s ability to pay off loans — the ratio of a business’s available cash flow to its debt obligations, including principal and interest payments on a loan. Once you know how to calculate DSCR, you can get a better sense of your finances and make strategic operating decisions that benefit your business.
The two most important components to calculate the DSCR ratio are net operating income and debt service amounts.
DSCR = Annual Net Operating Income / Annual Debt Service
Net Operating Income: Gross income minus operating expenses
Debt Service: The sum of all current debts, including principal and interest
A deeper dive into the definitions will help you understand these terms better.
- Net Operating Income: Pre-tax amount reflecting gross income less operating expenses, such as cost of goods sold, taxes, rent or lease payments, equipment, parking, amortization and interest in a given period; does not include capital expenditures, such as acquiring or maintaining fixed assets; is not the same number as EBITDA
- Debt Service: Cash needed to pay required principal and interest of a loan during a given period
DSCR calculation example
An example can help you understand how to calculate DSCR. In this example, net operating income is $1 million, and debt service is $200,000.
$1,000,000 / $200,000 = 5
With a DSCR of 5, this business can cover its existing debt obligations five times over with its current net operating income. When you calculate DSCR, a higher number is better, since it indicates more latitude to cover debts and shows a business is in a better position to cover repayment of a loan. A DSCR of less than 1 means a business’s cash flow can’t cover its debt obligations and reliably repay outstanding debts.
A DSCR of 1 means a business has exactly enough net operating income to cover its debt obligations. This is a tight margin; ideally, businesses want to aim for a minimum DSCR of 2 or higher. There is no universal standard for what constitutes a “good” debt coverage service ratio. Lenders have specific requirements relative to what they are looking for in a loan candidate.
Why is your DSCR important?
For businesses with outstanding debts, the DSCR is a crucial number, since it provides insight into a company’s ability to pay off those debts, including both principal and interest. Knowing how to calculate a DSCR and understanding what the resulting number means can help you evaluate your own business’s finances and enable you to identify areas that need improvement, such as lowering operating expenses to produce a higher net operating income.
The DSCR is not just useful for financial management — lenders use a company’s DSCR when evaluating prospective borrowers that want to get a business loan. Debt service coverage ratio helps lenders get a sense of how risky a loan candidate may be; a low or negative DSCR indicates a high-risk borrower, which is less desirable than a candidate with a high DSCR.
Generally, a good DSCR helps businesses attain:
- Higher loan approval odds
- Lower loan interest rates
- More options for types of financing tools
- Improved internal operations
Ways to improve your DSCR
Improving DSCR primarily requires you to either reduce debt or increase income. Tips and strategies for doing so vary by industry. Generally, however, approaches to improve debt service coverage ratio include the following:
- Negotiate better contract terms. To bring down net operating expenses, businesses can try to negotiate lower prices and better terms on things like raw materials or shipping or by changing vendors entirely.
- Reduce interest rates: Businesses can try to refinance loans for a lower interest rate on debt.
- Pay off existing debt: If possible, businesses can try to pay off some existing debt to reduce the amount of debt owed overall.
- Work with a financial professional: Financial professionals can help businesses evaluate your financial statements, such as a profit and loss statement, cash flow statement and balance sheet to help identify ways to improve net operating income, such as by boosting gross income and lowering operating expenses.
Track your business vitals
A good DSCR can help businesses in many ways. First, it can enable you to get an important insight into the way your business runs, so you can strategically manage your operations and generally improve your business’s financial health.
Additionally, a strong DSCR may help improve a business’s likelihood of being approved for loans with favorable terms, including higher amounts, longer repayment timelines and lower interest rates. Improving your debt service coverage ratio before you apply for another loan can be a good strategy, since it can better your odds of getting approved for the financing you want.
For businesses with lower debt service coverage ratios, there are ways to improve the ratio and put your business in a better position to cover debts, as well as to indicate to lenders you are a strong candidate for a loan.
Formulating an approach to improve DSCR is important and often involves strong bookkeeping and accounting expertise. Businesses can get started with First Republic business resources such as Small Business Bookkeeping 101 and consult with First Republic financial professionals to manage their overall financial health.