What Is Debt Service Coverage Ratio?
The Debt Service Coverage Ratio also known as DSCR is calculated by dividing a business’ yearly net income by the annual debt payments. Investors and lenders use this to assess a business' cash flow and how profitable a company is. A DSCR of more than 1 suggests that a company's income is sufficient to cover the loan principal and interest payments.
When applying for small business loans, lenders need to assess whether you are qualified enough to be eligible for a loan. To do so, they use various qualitative and quantitative methods. The Debt Service Charge Ratio is one of the most important ones. It is because it answers the most important question of whether you can pay back the full amount of the loan in time or not.
The DSCR is not just a simple formula where you plug in figures to find an answer. But rather you have to know how to interpret your results. And what data to enter into the formula for an accurate result.
Debt Coverage Service Ratio Formula
Different lenders may have different methods of calculating your debt coverage service ratio. So, it is important that before you start applying you should ask how the particular lender calculates the DCSR. The most common formula for calculating this ratio is:
DSCR = Business’s Yearly Net Income / Business’s Annual Payments
Lenders need to know the full extent of a company’s debt. Including previous ones so that they know whether you would be able to pay them back or not. But business owners make a common mistake while using this formula. They only include the debt payments of the loan they're applying for and not their previous debts.
Here are some examples of the types of debts you should include while calculating your Debt Coverage Service Ratio:
- Online and bank loans
- Short term loans
- Equipment and other kinds of leases
- Business credit cards and business lines of credit (estimate your monthly installment payments)
Lenders want a holistic view of your finances and debt service. So, you have to notify them of any kind of lease, credit card and any other kinds of debts you have.
“For loans with longer terms, lenders tend to place a heavier emphasis on your DSCR score unlike short-term loan lenders.”
Why Debt Service Coverage Ratio (DSCR) Is Important
Most lenders need the debt service coverage ratio to assess your loan application. It is to see whether you can pay back the installments or not. The DSCR gives important insight into your financial position and whether they should consider your application or not. Every lender is different but most look for a DSCR score of at least 1.15.
- DSCR > 1: A positive cash flow. The higher your score on the DSCR the stronger your ability to pay off your debts and interest
- DSCR = 1: Your income is just enough to manage your debt but you have no additional cash left in case of an emergency
- DSCR < 1: A negative cash flow. Your income is not sufficient to pay off all your debt nor to support further loans
For loans with longer terms, lenders tend to place a heavier emphasis on your DSCR score unlike short-term loan lenders. It is because they get their money back faster and place heavier importance on credit history.
Your business is helpless and vulnerable if you don't have a strong cash cushion to fall back on. If your business has a slow month or season, you won't have anything to cover your expenses. To avoid situations like this, lenders use the DSCR. This is to ensure that you have enough cash flow to cover up these situations. To be extra cautious some lenders even use a global debt service coverage ratio that includes personal income and debt into the calculation.
A global DSCR is a more in-depth formula of the DSCR. It takes into account personal investments, incomes and debts. Some things that could come into consideration would be mortgages, student loans, car loans etc. In some cases, they may also consider the debt of business partners and loan guarantors.
And if your personal finances have been managed well then it may boost your debt service coverage ratio score. And facilitate you to qualify for the loan you want. On the other hand, if you have a lot of debt collected the global DSCR would do more harm than good.
How To Improve Your Debt Service Coverage Ratio
If the only thing standing between you and qualifying for a business loan is your DSCR score then don't worry. Here are two easy ways to improve your score easily:
- Improve your business revenue: Implement creative and innovative marketing strategies to boost your revenue, which will further improve your DSCR score.
- Reduce your business operating expenses: Look through your profit and loss statements or discuss them with an accounting professional who can advise you on effective ways of cutting costs.
Even with a low score you may be able to convince a lender that you can improve your score by reducing your costs and improving your revenue. You can improve your DSCR score to qualify for certain lenders by making a few simple changes.
You may also have to maintain a certain debt service coverage ratio while you're in the middle of paying off your debts. So, it is incredibly important to invest time and effort into improving and maintaining a good DSCR score. Ensure that your score is continuously at a certain level otherwise random checks done by lenders could cause you to violate your agreement terms. And so, you can end up paying extra fines or it can even result in contract termination.
The Bottom Line
The DSCR is essential to lenders because it helps them assess your ability to pay back loans. And can determine whether your loan application will get accepted or rejected. Having a good ratio would improve your chances of getting a loan and benefit your business' finances.