If you're considering taking on a business loan to help you to grow your business, you need to know whether you're taking on too much debt. One way to measure the burden that a business loan places on your company is to calculate the debt service coverage ratio. This is the ratio between the cash you have available to service your debts and the total amount of debt you need to service.
There are several methods of calculating debt service coverage ratio. Let's take a look at the options, so you can work out which one is most appropriate for you.
The most common method of calculating debt service coverage ratio (DSCR) is to divide your company's 12-month EBIT (earnings before interest and taxes) by the debt payments you need to make over the next 12 months.
Another option for calculating the DSCR is to divide the 12-month EBITDA (earnings before interest, taxes, depreciation and amortization) by debt payments over the next 12 months.
Calculating EBIT and EBITDA
Calculating your earnings before tax and interest is relatively straightforward. In most cases, EBIT is similar to the operating income of a business. On the other hand, EBITDA takes into account depreciation and amortization, making it a much more accurate measurement of the amount of money available to service debts for businesses with high depreciation and amortization (which are non-cash expenses). You can think of EBITDA as equivalent to cash flow for most businesses.
How to Calculate Debt Payments
To calculate your debt payments, you need to look carefully at your agreements with your lenders. What is your minimum monthly payment for each loan? Do you plan to make larger payments to repay the amount more quickly? Remember to add up payments on all the debts that your company holds.
Why DSCR Matters
DSCR is the best measure of the affordability of a loan. It's much more effective than simply looking at the overall value of the debt. As a business, your primary concern should be protecting your cash flow to ensure you always have enough resources to stay on top of any loan payments.
Once you have calculated your DSCR, you can see whether it is good enough to justify taking on a business loan. Most lenders require a ratio of at least 1.0, with a ratio above 1.5 strongly preferred.
When DSCR Matters Less
DSCR isn't such a good measure of debt affordability when a business is growing very quickly. That's because the EBITDA over the last 12 months isn't a great prediction of income over the next year for that kind of business.
One way to get around this problem is to calculate a 3-month DSCR as well as a 12-month measurement (one of the metrics Able uses). This puts more weight on recent growth and developments. Unlike projected EBITDA, this is a concrete, historical metric, but it does give more weight to high-growth businesses.
DSCR is also less important when your operating income is artificially high or low. This can happen when you are rolling profits back into the business to drive growth. Able takes this into account, giving more credit to high-growth and early-stage companies.
How Much Can You Afford?
Do you want to know how much debt your business can afford to take on? See how much you qualify to borrow using Able's pre-approval calculator (no impact to the credit score).