What Is a Good Debt Service Coverage Ratio?

  • By The Able Team
  • Published 10/17/2016

Debt service coverage ratio (DSCR) is a common benchmark used by lenders to decide if a business is a good credit risk. DSCR is a way of showing whether your operating income is sufficient to cover the full cost of all your debts, including loan principal, lease payments and fees.

Calculating Your Debt Service Coverage Ratio

To calculate your debt service coverage ratio, the first step is to calculate your annual operating income. To do this, you start with your net income, and then add back into it your interest payments and taxes.

The second step is to get a number for your annual debt service (i.e., your current and proposed indebtedness). To do that, add up all your current lease payments, loan payments and fees. Include the cost of the new loan, as well.

Now divide your annual operating income for the year by your annual debt service to get your debt service coverage ratio. If you’ve seen big changes over the past year, you might also do the same calculation looking at only the past three months.

Note: For the numerator, some lenders use EBITDA, which is the net operating income with the depreciation and amortization expenses added back in. Some lenders might also add the owner’s salary back in, as well as any unusual expenses that won’t recur.

What Debt Service Coverage Ratio Means

Debt service coverage ratio is a metric designed to measure your ability to meet your debt obligations without dipping into cash reserves. A debt service coverage ratio of 1 means that you have just exactly enough income to cover all your debt costs, with nothing left over to cover unexpected events. If it’s above one, it means you have more than enough operating income to pay all your obligations. If it’s less than 1, it means you lack the cash flows to cover all your debt costs.

Most lenders require a debt service coverage ratio of at least 1.0 (for obvious reasons). Most lenders will require a debt service coverage ratio of 1.25 or higher, because that shows you can pay your bills, as well as any unexpected expenses, and still have excess to invest in the company. But a higher debt service coverage ratio (1.5 or above) is generally preferred.

Conversely, a debt service coverage ratio of less than 1 means that your company is not generally considered credit-worthy, because you don’t have enough cash flow to cover your regular expenses. Some lenders will still consider you (most banks won’t), but you’ll pay a higher rate, but even those will typically draw the line between 0.5 and 0.7 debt service coverage ratio.

If your debt service coverage ratio is negative, however, it means that you’re net operating income is actually a net operating loss — meaning you’re cash flow negative. In that case, your financing options will be extremely limited — mostly to merchant cash advance companies, specialty financing and factoring, and a handful of term lenders like Able that specialize in companies with negative debt service coverage ratios.

Lending with a Negative Debt Service Coverage Ratio

Sometimes, debt service coverage ratio doesn’t tell the whole story. That’s particularly true in three situations.

The first is high-growth companies, where the company is aggressively reinvesting the profits in growth. High-growth companies tend to either be profitable or have a clear path to profitability, and so they can often pull back on the investments to service debt.

The second is high-growth projects, where the company has a clear avenue for turning $1 in lending capital into $2 in income. In that scenario, the debt service coverage ratio isn’t entirely accurate because it doesn’t account for the reasonably expected future income that will result from the project. When you add that in, a business’s effective debt service coverage ratio might be much higher.

The third is for refinancing short-term debt. For example, simply increasing the term of a loan can dramatically reduce the monthly debt obligations, and therefore increase debt service coverage ratio. In that scenario, refinancing existing debt could strengthen the business’s cash flow cash flow enough to bring the debt service coverage ratio into healthy territory.

We understand that your business is more than just one metric, especially if it’s growing quickly. We’re happy to talk with you about a business loan if you have a low or even a negative debt service coverage ratio.

You can see how much you might qualify for here.

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