The most important metric most small business lenders look to is debt service coverage ratio (or a proxy). That’s because debt service coverage ratio is a quick metric to assess whether a company can afford to repay its business loan.
In short, the key to securing a low-interest small business loan is having a healthy debt service coverage ratio. What that term means, what a good ratio looks like and how to improve it, are questions that deserve your immediate attention.
What Does DSCR Measure?
Your current debt service is equal to how much cash you need to pay principal plus interest on your existing debt over a given period of time. Your DSCR is the ratio of the cash you have available for a given time period divided by what you owe.
However, your earnings as listed on your income statement alone don’t offer a clear picture of actual cash on hand that’s available to spend. For the purposes of DSCR, lenders will usually want you to calculate your solvency using earnings before interest, taxes, depreciation and amortization (EBITDA).
In effect, EBITDA stands in for operating cash flow, even though this is not something that is required by or even defined by GAAP (generally accepted accounting principles). What lenders want to know from the DSCR is how feasible it will be for your company to pay off your debts in full based on your profits.
The formula is:
DSCR = EBITDA/debt service
What’s a Good DSCR?
Banks and other lenders normally look for a DSCR of 1.25 or better. This lets them know that your profits are sufficient to cover your debt payments plus any unexpected bumps along the road. A DSCR of less than 1 means that you are operating with negative cash flow, which can’t go on for long.
3 Ways to Improve Your DSCR
Compared to some financial metrics you’ll be working with as your business grows, DSCR is one of the simplest to fix. All you need to do is raise the numerator (increase your profits) or lower the denominator (cut your debt payments). What companies normally do is:
1. Cut down on debt service by refinancing existing debt over a longer term. Smaller payments may be your most responsible move until you are able to grow your customer base or your margins.
2. Boost profits by slashing operating expenses. Buy in bulk, renegotiate contracts, ratchet up efficiencies, etc. If your revenue is stable, you’ll have to trim fat to move the needle on profits.
3. Invest in longer-term projects designed to drive greater revenue growth. This may seem counterintuitive, which is why it is less common than the other strategies. But if you can demonstrate to a lender that you have a plan to make revenues trend upward in the near future, a lower current DSCR starts to look more attractive. In fact, a DSCR greater that 2 can look bad because it indicates the company is not making wise use of its capital.
Refinance Short-term Debt with Able
Able is one of the best places to look into your refinancing options. Able was created by business professionals who want to see small businesses succeed. The future of your business depends on making the smartest financing moves as early as possible.
See how much you qualify for — and how much you can save — here (no impact on your credit).