Understanding the Debt-Service Coverage Ratio

What is the debt-service coverage ratio (DSCR)?

The debt-service coverage ratio (DSCR) is essentially a numerical figure that represents your business’s ability to repay its debts. It’s calculated by dividing your business’s net operating income by its total debt service obligations over a specific period, usually a year. A simpler way to think about it is comparing the money your business makes to the money it owes. If your DSCR is 1.00, that means your net income exactly covers your debt payments. Most lenders look for a DSCR higher than 1.00, indicating you have more income than debt and can comfortably manage additional loan payments. A lower DSCR, on the other hand, signals potential risk to lenders, as it suggests your business might struggle to meet its debt obligations.

How do you calculate your DSCR?

You can easily calculate your DSCR once you have your ledgers balanced and have developed a clear picture of the financial risks associated with your business. 

This is the formula to track your debt-service coverage ratio:

Net Operating Income / Debt Service

For example, if you took out a $20,000 loan and have a net operating income of $30,000 for the year, your DSCR is 1.5 ($30,000/$20,000).

Once you calculate your DSCR, you can evaluate whether your income and proposed debt are proportionate or if you need to make changes to become profitable. Here is how you read the ratio:

• If your DSCR is greater than 1.00, you have the operating income necessary to pay off the debt.  
• If your DSCR equals 1.00, you have just enough operating income to cover your debt.  
• If your DSCR is less than 1.00, you do not have the operating income you need to cover your debt. 

Continuing the example, if your business has to close for 6 months and you only have an operating income of $15,000, a $20,000 loan would place your DSCR at 0.75.  

Most lenders prefer applicants to have a DSCR of at least 1.25. This creates a safe cushion in the event that a company’s net operating income decreases unexpectedly.

What is net operating income?

As you learn about the debt-service coverage ratio, you may want to take a step back and learn about net operating income—an important term to help you calculate your DSCR. 

Net operating income tracks a company’s ability to generate a positive cash flow. It is calculated by subtracting your operating expenses from your gross operating income (or revenue). 

For example, someone who owns a real-estate rental property might collect $1,000 each month in rent and $75 monthly in fees for internet and utilities. The landlord would have $1,075 in gross operating income. The operating expenses would include taxes, home insurance, and upkeep like a lawn service. If these expenses cost $475 total, the landlord’s net operating income would be $600.

Why does DSCR matter?

Understanding your debt-service coverage ratio (DSCR) isn’t just about getting through the door with lenders—it’s about financial health and strategy for your business. It matters because it provides both you and potential financial partners with a clear, quantitative measure of your company’s ability to manage and service its debt with the income it generates.

In a real sense, DSCR is a litmus test for financial stability. A strong DSCR indicates to lenders that your business has a healthy cash flow, making it a lower-risk investment. For you, it’s a signal that your business operations are generating enough profit to comfortably handle your current debt obligations, plus some. This can give you the confidence to pursue expansion or improvement projects, knowing that your fundamental finances are solid.

Furthermore, understanding and improving your DSCR can open doors to better loan terms, including lower interest rates, more favorable repayment schedules, and higher borrowing limits. In contrast, a lower DSCR might prompt a reassessment of your business strategies and financial management practices to bolster your operating income or reduce debt, protecting your business from over-leveraging and financial distress.

Remember, lenders and financial analysts see the DSCR as a direct reflection of your business’s financial health and its future prospects. That’s why paying attention to this ratio isn’t just about securing loans—it’s about securing your business’s future.

What is a good DSCR?

A “good” DSCR is somewhat subjective and can vary by industry, but as a rule of thumb, lenders typically look for a ratio of 1.25 or higher. This benchmark indicates that a business has enough income to cover its debt obligations with a little room to spare, which in turn suggests financial resilience. Specifically, for businesses operating in sectors with more predictable cash flows, such as manufacturing or retail, a DSCR closer to 1.00 might still be acceptable because their income streams are more consistent. On the other hand, industries subject to seasonal variations or cyclical demands, like agriculture or construction, might need a higher DSCR to account for periods of reduced income.

It’s crucial to understand that a higher DSCR not only improves your chances of loan approval but also may result in more favorable loan terms. This is because lenders perceive a lower risk when a business demonstrates a strong ability to generate profit in excess of its debt obligations. Conversely, a DSCR below 1.00 is a red flag, signaling potential difficulties in meeting debt payments which might necessitate immediate financial restructuring or strategic adjustments to improve profitability.

In essence, while the “ideal” DSCR can vary, aiming for a ratio that comfortably exceeds your lender’s minimum requirement is a wise strategy. It positions your business as a sound investment and provides you with leverage during negotiations, potentially saving your business significant amounts in interest and fees over time.

What do lenders learn from your DSCR?

The DSCR is an indicator of risk for your business loan. If you have a low DSCR (or a ratio that is close to 1.00), you are more likely to default on your loan. You may have to miss payments if you don’t maintain your net operating income or you may require additional loans to cover your costs.  

A low DSCR can also cost your business money. Not only are you more at risk for a loan denial because of this ratio, but your lender may charge higher interest levels and have fewer forgiveness options if you get approved. 

You could end up paying more fees and extra expenses to the lender in order to pay off the loan. Your lender might also require you to pay off the loan faster, limiting your other business investment opportunities.

How to improve your DSCR.

There are multiple steps you can take to improve your DSCR, but few offer easy solutions. You may need to make significant adjustments to your business to improve your financial standing. A few options include:

• Decreasing your operating expenses. (Lower payroll costs by adjusting your staff, cancel a few non-essential services.)
• Pay off some of your existing debt. (Wait a few months until your debt is lower to apply.)
• Decrease your borrowing amount. (Take out a smaller loan and apply again after you pay that one back.)
• Increase your net operating income. (Find ways to grow your sales without driving up costs.)

Each solution will have its own benefits for business owners. Some will find it easier to lower their borrowing amount, while others will want to cut expenses to get the funds immediately.

Know your DSCR before you apply for a loan.

You can reduce your risk of loan rejection by calculating your DSCR beforehand. You can understand how likely it is that your loan will get denied based on this score. A higher DSCR isn’t a guarantee for approval, but it can make your loan application look better.

Get to know some of the loan options through Lendio’s comparison guide. You can get an idea of the amount of funding you need and the flexibility required to spend the money how you want. Find what works for you today.