If you’ve ever applied for a small business loan, you know that there are a lot of steps involved. You have to submit financial documents, undergo a credit check, and more. But out of all the things that go into applying for a loan, do you know what is one of the most important deciding factors? It’s a little number that lenders call your “debt-service coverage ratio.”
What is a debt-service coverage ratio?
The debt-service coverage ratio (DSCR), which is sometimes referred to as the debt coverage ratio, is the ratio of cash a business has available for servicing its debt. It’s the mathematical equation that allows lenders to know whether or not you can actually afford to repay your potential loan — which is, of course, the question lenders want answered.
As a small business owner searching for a business loan, this debt-service coverage ratio is one of the bottom-line factors that will determine whether or not you’ll qualify for a small business loan — so it’s something you should understand completely and track regularly.
If you approach your financing search with DSCR in mind, it will help you better understand responses you receive from lenders.
Why is the DSCR important?
The debt-service coverage ratio is important because it’s the financial scale a lender uses to determine whether or not your business produces enough cashflow to cover the cost of your loan, including payments on principal, interest and fees. But that’s not all lenders look for when calculating your DSCR.
In business, unexpected expenses can arise. In fact, they’re almost guaranteed to do so! That’s why lenders want to see that you have some extra padding in your bank account. If, for example, a piece of equipment breaks and you need to replace it, lenders want to make sure you will be able to cover the unexpected cost without defaulting on your loan payments.
Generally, lenders will probably want to see a minimum DSCR of 1.25 — but that number can vary. Some lenders may accept a lower DSCR, others might want to see something even higher than 1.25.
How to calculate the debt-service coverage ratio
Now that you understand exactly what the debt-service coverage ratio is and why it matters, how exactly do you determine what yours is?
To calculate the debt-service coverage ratio of your business, divide your cash flow by your loan payment. Here’s the formula you’ll need:
Annual Net Operating Income + Depreciation & Other Non-Cash Charges /
Interest + Current Maturities of Long-Term Debt
For example, if your company has a total annual net operating income of $20,000 and your debt service will be $16,000 for the year, your debt-service coverage ratio will be 1.25.
Also, if you are currently financing a different loan, lenders will also include your other debt in their DSCR calculations.
Monitoring your DSCR
Now that you know how important your debt service coverage ratio is to lenders and your loan eligibility, you’ll want to make sure you monitor it carefully. The first step in monitoring your DSCR is to know what your current ratio is and know how each lender calculates it.
In addition to helping you qualify for a loan, your debt-service coverage ratio also gives you some insight into the health of your company’s cash flow. So always monitor this number as carefully as you would your profit margin and other financial indicators — even when you’re not actively applying for a loan.
By maintaining a respectable DSCR, you’ll put your business in a good position to be approved for a small business loan or line of credit and grow your business in the future.
The above content should not be construed as legal or tax advice. Always consult an attorney or tax professional regarding your specific legal or tax situation.