Lenders use a variety of quantitative and qualitative metrics to determine your eligibility when you apply for small business loans. Among all these metrics, DSCR stands out because it answers the core question every lender is trying to answer: Are you able to repay the loan in full and on time?
The lender will use your business’s DSCR to determine if you are able to take out a small business loan. It also helps you decide how much money you can approve and what terms the financing will be.
It’s not as easy as just entering numbers into a formula to calculate DSCR. Understanding how to interpret the result, what goes into it, and which lenders will check DSCR is important. This article will explain all this and how to increase your DSCR if you don’t have a high enough ratio to be eligible for the best financing. This video will explain why this metric matters.
Debt Coverage Service Ratio Formula
Different lenders may have different methods of calculating DSCR. Ask your lender early in the loan application process if they use DSCR to calculate this ratio. This is the most commonly used formula to calculate debt service coverage ratios (DSCR).
Debt service coverage ratio (DSCR), = Annual Net Operating Income of the Business / Annual Debt Payments.
The DSCR must take into account both existing debt and the loan you are applying for. When calculating their debt service coverage ratio, business owners often only account for the loan they are applying for. Lenders must see how all of your business debt, as well as any business debt, affects your ability to repay the loan.
These are all types of debt you should include in your DSCR Formula:
- Online loans and bank loans
- Short-term loans
- Leases (such as equipment leasing).
- Invoice financing
- Business credit cards and business lines of credit (you can calculate your monthly payments to calculate the debt service on a line of credit or credit card).
All kinds of debt can impact your cash flow and your ability to repay a loan. Be prepared to include all debts in your DSCR calculation. Lenders need a complete picture of your debt service. You’ll need to inform them about credit cards, leases, and lines of credit as well as other types of debt.
Why is Debt Service Coverage Ratio, (DSCR), Important
When considering a loan application, lenders will look at the debt service coverage ratio (DSCR). This ratio is particularly important as it gives the lender an indication of your ability to repay the loan and interest. Although every lender will be different, the majority of lenders that evaluate DSCR require a ratio of 1.15 to 1.25.
How to interpret your DSCR.
- DSCR > 1: Your cash flow is negative. You don’t have enough income for all your debts.
- DSCR = You have enough cash to pay your debts, but not enough money to cover the unexpected.
- DSCR > 1. You have positive cash flow. Your DSCR is a measure of how much income you have available to repay your debt.
Lenders will place more importance on DSCR for the larger and longer-term loans you apply for. Because short-term lenders are able to get their money back faster, they tend to rely more heavily on credit history and monthly incomes than on DSCR. They don’t want their investments to be lost or the hassle of following up on a defaulting borrower. They want to be reassured that your business will continue to generate enough income to repay the loan and interest.
Your business will be vulnerable if you don’t have a solid cash cushion. If sales slow down, or a large client leaves your company, you could fall behind in loan payments. Lenders can use the DSCR to get a view of your cash flow and see how much cash you have available to pay your loan payments. They can also assess your ability to run your business comfortably. Lenders may even use a global default service coverage ratio (DSCR), which includes personal income and personal debt.
The global DSCR is more flexible than the traditional DSCR formula. The lender may consider income streams such as personal investment income and day jobs when calculating your net income. They will also consider student loans, home loans, car loans, student loans, and other personal loans in your total debt service. Global DSCR lenders might also consider income and debt from business partners or loan guarantors.
Accounting for your personal income streams can help boost your ratio and make you eligible for the loan if you have managed your personal finances well. However, if your personal debt is excessive, you might not be eligible for the loan.
How to Increase Your Debt Service Coverage Rate
Don’t worry if your debt service ratio prevents you from qualifying for a loan. You can improve your DSCR in two ways:
- Increase your company’s revenue: Finding new ways to increase your DSCR can help you. You can negotiate a higher salary or increase the price of your product/service.
- Reduce your business’s operating costs: Another method to increase your DSCR is looking through your profit & loss statement and speaking with your accountant to discuss cost-cutting options. Reduce staffing and negotiate a lower rent with your landlord.
Even though your ratio may be low, the lender might be able to convince you that you are going to increase it by increasing revenue or cutting expenses. David Rewcastle, the senior analyst of E3 Research Associates, an Independent Third Party Research and Analytics Company, was able to explain the loan.
Rewcastle says that you can improve the DSCR by looking for cost-saving opportunities. “In our case, we made some small staffing adjustments in our go-forward operational plan, which we submitted to the lender in order to account for recent changes that were not in the historical financials.”
It is worth taking the time to improve your DSCR. This ratio will be more than what you apply for in your business loan application. You’ll need to keep a sufficient debt service coverage ratio while paying off a loan, depending on the loan agreement.
Lenders may periodically assess your debt service coverage ratio. You should keep your business’s finances under control on a monthly and quarterly basis to ensure that your debt service coverage doesn’t decrease, which could lead you to breach your loan agreement.
The bottom line
The metric of debt service coverage (DSCR), which lenders use to assess your ability to repay a loan, is important. Your chances of getting a loan are increased if you improve your ratio. This will also help to improve your overall financial health. That’s always a good thing.