What Is Debt-Service Coverage Ratio?

Moyo Studio/ Getty Images; Illustration by Austin Courregé/Bankrate

For a small-business loan, debt-service coverage ratio (DSCR) is a metric that compares a company’s cash flow against its debt obligations. Business owners and investors can use DSCR to understand if the company is generating enough net operating income to cover existing debts, including principal and interest.

DSCR can help inform future business decisions, including whether a company has the financial ability to repay its existing business loans and take on more debt. It also helps lenders assess the strength of business loan applications and how much risk they’ll take on by lending to you.

How to calculate debt-service coverage ratio

The two main components needed to calculate DSCR are annual net operating income and annual debt service:

DSCR = Net operating income / Debt service

To calculate net operating income, you’ll want to look at the business’s pre-tax revenue minus operating expenses, such as wages, rent and cash taxes, for a given period of time:

Net operating income = Revenue – Operating expenses

Debt service is the total of all existing debt payments owed by the company due in the same period. This should include all interest and principal.

It’s important to note that some lenders and financial professionals use different versions of this formula to calculate DSCR. For example, the Corporate Finance Institute (CFI) outlines the DSCR formula using EBITDA — short for earnings before interest, taxes, depreciation and amortization — in place of net operating income. If you’re calculating DSCR to understand your company’s income vs. debts, make sure to be consistent with the formula you choose.

DSCR example

As an example, let’s say that your business has an annual net operating income of $100,000, with a total debt service of $50,000. In that case, your DSCR would be 2, meaning that you can cover your current debt twice over.

Why does DSCR matter?

Keeping track of your DSCR helps you understand the general financial health of your business. It provides a concrete number — rather than a general idea — to help you assess the gap between how much money you’re bringing in and how much is going toward debt.

When it comes to getting approved for a small-business loan, a strong DSCR indicates that your business has figured out how to balance revenue generation with debt repayment, and is therefore likely to repay any new debt. In addition to getting approved for a new loan, a better DSCR — especially when paired with other indicators of financial health, such as a high business credit score — can mean more favorable loan terms like lower interest rates and fees.

What’s a good DSCR?

A DSCR of 1 means that 100% of your net operating income is currently going toward debt, which will make it difficult for your business to take additional loans. For that reason, most lenders require a DSCR above 1, though exact requirements can vary depending on the lender. The SBA, for example, tends to look for a DSCR of at least 1.15, while  many banks require a minimum 1.25 DSCR. An ideal DSCR of 2 means your business has twice the amount of income it needs to meet minimum debt obligations.

Current economic conditions matter, too — lenders might require a higher DSCR from potential borrowers at times when the economy is rocky, and many businesses are defaulting on loans.

In any case, it’s important to remember that DSCR isn’t the entire picture, and lenders will determine their own requirements. They’ll also take into account things like your industry and company age when evaluating your loan application.

How to improve your DSCR

The best way to improve your DSCR is to work on increasing profits, reducing debt or, better yet, both.  Beyond boosting sales, you may think about how to cut certain expenses. For instance, can you negotiate with vendors to lock in lower prices? Can you trim utility or labor costs? In terms of debt reduction, are you able to refinance your current loans and lock in a lower rate?

The bottom line

Whether you’re preparing to secure another round of financing or you just want to take a better look at your company’s financial well-being, understanding your business’s DSCR is a useful exercise. If it’s not quite where it needs to be, there are ways to improve it. Start by turning your efforts toward driving revenue while reducing expenses and existing debt.

Frequently asked questions

• What is a good debt-service coverage ratio?

  Most lenders want to see a debt-service coverage ratio of at least 1.25. But, lender requirements will vary depending on the type of business loan and lender you select.

• Is a higher DSCR better?

  Yes, a higher DSCR is better. While a DSCR of 1.25 is the minimum requirement for most lenders, a higher number — such as 2 — shows lenders you are financially stable and can repay your debts. A higher DSCR can also mean a potentially lower interest rate as lenders see you as less of a risk for defaulting on your business loan.

• How can I increase my DSCR?

  To increase your DSCR, you’ll want to look at lowering the amount of debt your business has and increasing profits. If increasing sales is something your business is struggling with, you can look at ways to cut costs in your business’s budget.If you’re having difficulty paying down debt, consider refinancing or consolidating your business loans.