Navigating the application process for a business loan can be confusing. While it can seem like there's no end to the jargon and complicated financial terms, it's best to start by focusing on the fundamentals.
One of the most important concepts to understand when you're considering taking out a loan is the debt service coverage ratio (DSCR, sometimes DCR).
Here's what you need to know.
What Is DSCR?
The debt service coverage ratio is used by loan providers to calculate and verify your ability to repay your business debt. In short, the number indicates the ratio of your annual debt costs to your annual income.
The formulas used to make that calculation vary widely depending on the context, and can grow very complicated for the biggest corporate debt scenarios. However, as a small or mid-sized business owner, most banks assessing your DSCR will use relatively simple formulas, similar to what would be used if you were applying for a personal, non-business loan.
Key Terms for Debt Service Coverage Ratio
These are the terms you should be able to define in order to navigate the calculation process.
All debt your business owes from any source, including business credit cards, other business loans and even things like payment arrangements on past-due utilities or vendor bills, as long as those arrangements are laid out in a written agreement
This term describes all the costs associated with your debt. The most obvious cost is your interest payments, but debt service also includes principal payments, servicing fees and any other amount you owe during the process of repaying that debt.
Annual Debt Servicing Costs
"Debt service" technically describes the total cost of your debt, but to calculate your DSCR, lenders are primarily interested in your annual servicing costs. For example, while you may owe $10,000 in total debt service costs for a five-year loan, your annual debt servicing costs would only be $2,000.
Annual Net Operating Income
This figure describes the total income your business makes after all other non-debt expenses have been accounted for. Most lenders calculate this figure without deducting the amount you'll owe for taxes, but that's not always the case.
How Is Debt Service Coverage Ratio Calculated?
The basic formula for calculating DSCR is:
Annual net operating income / annual debt servicing costs
For example, if your annual net operating income is $100,000 and your annual debt servicing costs are $75,000, your DSCR is 1.33.
Most lenders require a DSCR of 1.25 or higher, although they may accept a lower ratio if you can demonstrate an ability to repay in other ways that aren't reflected in your net operating income.