It’s easier to get a small business loan if you know what lenders want from you as a borrower. Your debt service coverage ratio (DSCR) is perhaps the most valuable piece of information your lender has to determine if you are a high-risk applicant. When you learn how to calculate debt service ratio, you’ll be empowered to apply with confidence.

Before You Calculate Debt Service Coverage, Understand What It Is

Debt service coverage ratio provides insight into a company’s incoming revenue and outgoing debt payments. Understanding the correlation is critical. You calculate the debt service coverage ratio by dividing a company’s net operating income by the debts the company owes.

Lenders look at this figure to estimate what risk is present and whether the company has the financial means to repay a loan. Most lenders use this figure or a variation of it. Not only do they use it to determine if they will lend to you, but also how large a loan to approve and what rates and terms to apply to the financing.  

Learning what this ratio is can help you communicate with your lender more directly. It also gives you insight into what you can do to encourage lenders to work with you. When you learn how to calculate DSCR on your own, you don’t have to apply for a loan and be blindsided by the outcome.

How to Calculate Your Business’s Debt Service Coverage Ratio

Here’s the challenge: It takes some time to calculate debt service figures like this, but the time you spend doing so is well worth the effort. Here is the basic formula:

Company’s annual net operating income / company’s annual debt payments = DSCR

It sounds simple, but many companies don’t have these figures directly available to simply plug into the formula. Let’s break down how to calculate debt service coverage ratio step-by-step.

#1 – Determine Annual Net Operating Income

Your annual net operating income is not necessarily all of the revenue your company brings in. Most of the time, lenders use Earnings Before Interest, Taxes, Depreciation and Amortization, or EBITDA. Because this is the way lenders do it, it’s best to use this method for your calculation of DSCR as well.

How do you calculate EBITDA, then?

Gather your documents and spreadsheets. Then, find your business’s net income. You generally should have this figure determined on your profit and loss statements and financial management documents. Your business’s net income is your annual revenue minus all expenses paid out during the year.

Now, take that net income and add back in those components of EBITDA – your taxes, interest, depreciation and amortization. Take the time to get this right. By using this, we can assess your company’s financial health no matter the industry, age, size or risks.

Here’s an example of how to do this. Let’s keep the figures simple for clarity:

First, calculate the Earnings Before Interest and Taxes (EBIT). You can find this figure on your business income statement. It represents just your revenue minus expenses.Company’s Annual Revenue: $400,000

Company’s Annual Expenses: $50,000

EBIT: $350,000

Now, to get your EBITDA, follow this process:

Calculate the depreciation of any tangible assets your company owns. This includes real estate, vehicles or other real property. You can find your depreciation figure on your cash flow statement. Locate your amortization expenses next. This is on the company’s profit and loss report within the cash flow statement.Company’s EBIT: $350,000

(Add) Depreciation and Amortization: $10,000

EBITDA: $360,000

This is your annual net operating income you need to  calculate your debt coverage ratio.

#2 – Determine Annual Debt Payments

The next step involves determining what your annual debt payments are. Debt payments include any loans you are paying. Most lenders also factor in the loan you are applying for into this equation (that’s what gives them an accurate figure to determine if you can afford the loan).

To calculate this figure, you’ll need to estimate the loan amount you wish to borrow, the interest rate and the term limit.

You can calculate different figures here later. For example, if you find your DSCR is not ideal, you can come back and change how much you are borrowing or the loan term to see if that can help you qualify.

To determine what your annual debt payments are, simply determine how much the lender expects you to pay towards your loan each year.Loan Amount: $320,000

Annual Percentage Rate (APR): 20 percent

Loan Term: 2 years

Annual Debt Payment: $192,000

To calculate this, you’ll divide the loan amount by the loan term (24 months). Then, to calculate the APR, you’ll divide this number by 12 to arrive at your monthly payment before interest. Next, multiply this number by 20 percent, your APR. This number represents your monthly loan obligation, including interest. Last, to calculate your annual debt payment, you will multiply this number by twelve.  This gives you the proper figure for debt payments. In this case, you’ll pay back $192,000 per year.

#3 – How to Calculate DSCR Properly

Now, we take the information we have gathered to complete the final step to get the DSCR value. Take the annual net operating income figure you’ve found and divide that by the annual debt payments. This produces your DSCR.

Here’s our example:Annual Net Operating Income: $360,000

Annual Debt Payments: $192,000

DSCR: 1.875

In this example, the DSCR has a debt service coverage ratio of 1.875, which is very good. That means that the company has 90 percent more cash flow coming into the company than is necessary to cover the debt payments.

Think of it this way: The bank wants to know how easy it will be for your company to make that monthly payment for the loan. It estimates this by figuring out how much you will need to pay back each year and how much income you will have coming in. The more cash flowing into the business above and beyond what you will pay out for the loan, the better.

What Is a Good DSCR?

Now that you know how to calculate debt service coverage ratio for your company, you can clearly see where your company stands in terms of financial health with the new loan. As noted previously, you can go back into the figure and change up loan amount, the interest rate and term. This can give you more of an idea of how much your operating cash flow can bear.

What is a good DSCR? That depends on the lender’s specific requirements. Each lender sets what they believe is a safe number. However, most often, anything above a 1.25 is considered a good ratio. However, lenders use a variety of factors to determine the level at which they will accept a borrower.

For example, when the business climate is good and the economy is thriving, companies may drop that level to 1.15. On the other hand, if conditions are poor and the outlook limited, they may increase the DSCR to as high as 1.5.

On the flip side, anything below a 1 is never ideal. Most often, this indicates negative cash flow would occur if you secured the loan. Your company simply doesn’t have enough incoming cash flow to handle the debt. Lenders rarely, if ever, will consider this level.

If your ratio figure isn’t what you hoped it would be, you can work on improving the number. The key is to find ways to reduce some of your debt and operating expenses, or to increase revenue. It’s a challenge, but an important step in solid financial management.

Is It Worth Learning How to Calculate Debt Service Coverage Like This?

As a loan applicant, the more information you have going into an application, the better. Lenders want to know the risk you present. When you learn how to calculate DSCR, you gain insight into your ability to pay back a loan and whether or not a lender is willing to work with you.

Most lenders do not publish the figures they are looking for readily. That is, it isn’t likely you can find their DSCR limit on their website. However, if you are able to talk with a lender openly about your goals, even before applying for a loan, you can gauge what risk level the lender is willing to accept. Importantly, if your DSCR is less than ideal, you can take action to improve your business’s overall financial health—as well as your chances for qualifying for a small business loan.  

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