What is Debt Service Coverage Ratio?
If you’ve applied for business financing, or have been thinking about applying for business financing, you may have come across the term “Debt Service Coverage Ratio” or “DSCR.” Put simply, this is a metric that gauges the ability of your business to meet existing or proposed debt obligations.
Since the ratio utilizes annual financials, it tends to be one of the many metrics used when underwriting for longer-term financing. But if your business does not have a strong DSCR, there are still plenty of financing options that don’t take DSCR into consideration.
How is DSCR Calculated?
Each financing company may tweak the formula but it is usually some variation of:
Net Operating Income is your business’s revenue minus operating expenses other than interest and taxes. In lieu of Net Operating Income, some lenders may use either Earnings Before Interest and Tax (“EBIT”) or Earnings Before Interest, Tax, Depreciation, and Amortization (“EBITDA“). As a short-hand method, you can start with the profit (or loss) on the business tax return and add back these itemized expenses.
Annual Debt Obligations are the required debt payments during the time frame reviewed (usually one year). They can include credit cards, leases, loans, mortgages, and automobile payments.
DSCR Formula Examples
The easiest way to visualize DSCR is by looking at a couple of examples. For these we will use the shorthand method whereby we start with the profit on the business tax return and add back the interest and depreciation expenses.
EXAMPLE 1
Revenue: $2,000,000
Profit: $105,000
Interest Expense: $10,000
Depreciation Expense: $5,000
Current Debt Obligations: $70,000
So what does a DSCR of 1.71 mean? For every $1.00 of debt due, this business has $1.71 available to service it. Another way of looking at it is the company has positive, operational cash flow of $10,000 each month (($105,000 + $10,000 + $5,000)/12 Months = $10,000) and only $5,833 ($70,000/ 12 Months = $5,833) of corresponding debt obligations.
Based on DSCR alone, this company could qualify for additional long-term financing. Let’s say the lender they are working with requires a minimum DSCR of 1.25 to build in a small cushion should the company’s financial situation change. To meet the lender’s standards, the maximum monthly debt cannot exceed $8,000 ($10,000/1.25 = $8,000). Any new, long-term financing must have a monthly payment of $2,167 ($8,000 – $5,833 = $2,167) or less.
EXAMPLE 2
Revenue: $4,000,000
Profit: $50,000
Interest Expense: $8,000
Depreciation Expense: $2,000
Current Debt Obligations: $65,000
In this case, the DSCR is below 1.00. That means for every $1.00 of debt due, this business only has enough cash flow to cover $0.92 or 92% of it. In other words, there is $5,000 of positive monthly cash flow to cover $5,416 of debts. To cover the shortfall, this company will likely have to dig into their cash reserves.
Based on DSCR alone, this company would probably not qualify for additional long-term financing.
Can a Business Still Qualify for a Loan if the DSCR isn’t Very Strong?
Yes! For longer-term lenders, DSCR may be offset with other strong financials or metrics. Although these won’t adjust the DSCR itself, they may help the underwriters feel more comfortable with the financing.
- Strong liquidity and/or cash balances
- Pledging additional collateral and/or equity
- Pro Forma financials showing the Return-On-Investment from the proposed financing
- Strong personal or business credit
- Making a large down payment or otherwise showing “skin in the game”
If DSCR is considerably below the lender’s minimum requirement, there are still options! Short-term lenders and funders generally offer terms of 18 months and under. Since the terms are shorter, these financing options generally care more about the business’s recent cash flow from their bank statements.