Your debt service coverage ratio (DSCR) is one way lenders evaluate whether your small business can repay a loan. Also referred to as the debt service ratio or debt coverage ratio, DSCR is calculated by dividing your business’s net operating income by your annual outgoing debt payments.

Debt service coverage ratio (DSCR) formula

The higher your DSCR, the easier it will be to qualify for a small business loan. DSCR will also help determine how much funding you’re approved for, as well as the rates and terms that apply.

How to Calculate  DSCR

While the debt service coverage ratio formula is straightforward, your DSCR calculation relies on having accurate information about your business finances. 

Before using the DSCR formula, you have to determine your net operating income and debt payments. This is measured on an annual basis.

1. Determine Annual Net Operating Income

Your annual net operating income (NOI) is calculated by subtracting your business expenses from your earnings. You can find this information using your profit and loss statements.

In this situation, your expenses are the cost of goods sold (COGS), including labor, transportation, materials and other operating costs—such as rent.

For instance, if you had $1.2 million in earnings last year and $200,000 in expenses, your net operating income is $1 million.

Earnings: $1,200,000

– Expenses: $200,000

_____________________

NOI: $1,000,000

In this example, $1 million is your annual net operating income you need to calculate your debt coverage ratio.

Some lenders will have different methods of determining your company’s cash flow for their debt service coverage ratio formula. Common variations include EBIT and EBITDA, as well as capital expenditures (CAPEX).

2. Determine Annual Debt Payments

The next step is to determine what your total debt service is. Debt payments include any existing loans you are repaying. Lenders might also factor in the loan you’re applying for to give themselves an accurate picture of whether you can afford the loan.

Your DSCR ratio is based on annual figures, so consider using a business loan calculator to confirm your debt payments. Remember, your annual debt service will change based on when your loan term begins.

For example, you have a $10,000 loan with an interest rate of 6% that has to be repaid in 12 months. If your loan term begins in January, that year you will make a total debt payment of about $10,328, including principal and interest.

But if your loan term begins in June, you will make a total debt payment of $6,024 in the first calendar year and a total debt payment of $4,304 in the second calendar year. In this scenario, your payoff amount remains the same ($10,328), but your annual debt service varies based on your term.

Add up all of your debt payments for a year to determine your total debt service. For the most accurate debt service figure, you can estimate the payments for the loan you’re applying for next.

To keep the numbers straightforward, let’s say you’re interested in borrowing $425,000 and will be repaying the loan in 12 months, starting in January. The interest rate is 8%. Using a business loan calculator to determine the amortization schedule, we can see the total repayment amount that year will be $443,641. 

For our example, let’s round up the repayment for the future loan to $444,000.

Annual Payments for Existing Loan A: $650,000

+ Annual Payments for Future Loan B: $444,000

_____________________

Total Debt Service: $1,094,000

3. DSCR Calculation 

The final step to get the DSCR is to take the annual net operating income figure you’ve found and divide that by the annual debt payments. This produces your DSCR.

DSCR = Company’s Annual Net Operating Income ÷ Company’s Annual Debt Service

Using our earlier figures, here’s a cash debt coverage ratio example:

$1,000,000 in Annual Net Operating Income ÷ $1,094,000 in Annual Debt Service = 0.91 DSCR

This also demonstrates why it’s important to estimate future loan payments when calculating your annual debt service. If you included only your existing loan, as we do below, your DSCR would be different.

$1,000,000 in Annual Net Operating Income ÷ $650,000 in Annual Debt Service = 1.54 DSCR

What Is a Good DSCR?

Calculating your DSCR helps you determine your company’s financial health. In general, the higher your DSCR, the better. But what is a good debt service coverage ratio?

Lenders have different requirements about what a good DSCR means. This threshold might change based on external factors, such as the overall health of the economy.

However, a debt service ratio below 1, as in the above example, indicates that a company is making less money than it needs to pay its debts. In this case, the business is unlikely to have enough income to make payments on any new debt.

A DSCR of 1 means that there is exactly enough money to cover debts.

A ratio that is more than 1 demonstrates that the business has more annual income than necessary to pay debts. A debt coverage ratio between 1.15-1.35 is considered good in most circumstances.

You might need to increase your debt service coverage ratio to boost your chances of getting a small business loan. Ways to improve your debt service ratio include:

  • Decreasing your borrowing amount
  • Reducing your existing debt
  • Increasing your net operating income

A woman looks down at her DSCR score.

Decreasing Borrowing Amount

Let’s go back to our earlier example, where we’re looking to borrow $425,000 at 8% interest for a 12-month term starting in January. Our current annual net operating income is $1 million, and there will be loan payments amounting to $650,000 from an existing loan.

Annual Payments for Existing Loan A: $650,000

+ Annual Payments for Future Loan B: $444,000

_____________________

Total Debt Service: $1,094,000

$1,000,000 in Annual Net Operating Income ÷ $1,094,000 in Annual Debt Service = 0.91 DSCR

A DSCR of 0.91 will make it difficult to qualify for a small business loan of $450,000. But what if a loan of $150,000 with those same terms could still help your business?

With an interest rate of 8% and a 12-month term, your total debt payment for the year would be $156,579—including principal and interest. Let’s round up to $157,000.

Annual Payments for Existing Loan A: $650,000

Annual Payments for Revised Future Loan B: $157,000

_____________________

Total Debt Service: $807,000

Let’s see how this revised debt service figure changes your debt coverage ratio.

$1,000,000 in Annual Net Operating Income / $807,000 in Annual Debt Service = 1.24 Revised DSCR

A DSCR of 1.24 puts your small business in the range of a good debt service coverage ratio, making it more likely that you’ll be approved for that small business loan.

Reducing Your Existing Debt

Let’s say you implement debt relief strategies and pay off your existing debt before applying for your next loan for $425,000. 

Based on the terms previously discussed, this would change your annual debt service to $444,000, and by extension, your DSCR would also change.

$1,000,000 in Annual Net Operating Income ÷ $444,000 in Annual Debt Service = 2.25 DSCR

Increasing Your Net Operating Income

You can also turn to creative ways to reduce your expenses, thereby increasing your income. If your net operating income grows, your DSCR will also increase—even if your debt service stays steady.

$1,750,000 in Annual Net Operating Income ÷ $1,094,000 in Annual Debt Service = 1.59 DSCR

While it’s a challenge, you’ll want to experiment with all of these strategies if you’re looking to improve your DSCR and qualify for a small business loan. This is a challenging but important part of your company’s financial health.

Get weekly business insights & expert advice to help grow your business.