A number of factors determine the amount of money that a business can borrow. A company’s borrowing capacity depends not only on its ability to handle the monthly payment but a number of other factors.
Lenders look at several financial metrics before deciding how much to lend to a company and at what interest rate. The debt-service coverage ratio is one of those important metrics that affects a company’s ability to borrow money.
So, let’s answer the question a business owner might ask: “How much can I borrow based on monthly repayments?”
What Is a Debt-Service Coverage Ratio?
Lenders want to feel comfortable that the borrower will have the financial resources to repay the loan. One way they gauge this ability is to calculate the company’s debt-service coverage ratio (DSCR).
When a company has a DSCR greater than 1, it has enough cash flow to meet its principal and interest payment obligations and has some cash left over.
If the coverage ratio is exactly 1, the company has enough money to meet its debt obligations, but nothing else is left.
If the DSCR is less than 1, the company doesn’t have enough cash flow and is likely to default on its loan payments and could face bankruptcy.
Here’s how to calculate a company’s debt-service coverage ratio:
The company’s debt service coverage ratio is calculated by dividing the company’s annual free cash flow — known as earnings before deductions for interest, taxes, depreciation and amortization (EBITDA) — by the annual amount of principal and interest payments on loans.
To see how this works, let’s take an example. Suppose we find the following figures from ABC Co.’s income statement:
Total sales: $1,000,000
Net profit: $80,000
Interest expense: $8,000
Annual loan payments with principal and interest: $98,000
A simple way to find EBITDA is to start with net profit and add back the deductions for interest, taxes, depreciation and amortization. In our example, the calculations would be as follows:
Debt-service coverage ratio = EBITDA / Annual loan payments
Debt-service coverage ratio = $147,000/$98,000 = 1.5:1
ABC Co. currently has a DSCR of 1.5 to 1. This means that the company has 50% more in cash flow after paying its annual loan payments.
What Is a Good DSCR?
In general, the higher the DSCR, the better. Companies with higher DSCRs are in a better position to withstand an economic downturn that reduces cash flow, but the company still is able to meet its debt obligations on time.
To put a good DSCR in perspective, consider that the Small Business Administration requires borrowers in its 7(a) program to have a minimum DSCR of 1.15. However, other lenders may have different standards and require a DSCR of 1.5 or even 2.0 to qualify for their loans.
To determine how much you can borrow based on the monthly payments, lenders will calculate how your debt-service coverage ratio will look after adding in the loan payments for a new loan.
Let’s go back to our example of ABC Co. Their lender is willing to accept a DSCR of 1.25. Because ABC Co. presently has a DSCR of 1.5, then it has some borrowing capacity. But how much?
If we assume the company’s EBITDA remains the same at $147,000, then we can divide that figure by 1.25 to get the available loan payments that meet this requirement.
$147,000 EBITDA divided by DSCR of 1.25 equals available debt service of $117,600.
Because ABC Co. already has an annual debt service of $98,000, you can subtract this figure from the $170,600 to get $19,600 in additional annual payments ($1,633 a month) that would be available to service a new loan.
Determining One’s Borrowing Capacity
Now we go to a loan payment calculator. For the purposes of this illustration, let’s assume the lender is willing to offer a term loan to ABC Co. at 10% interest repayable over 10 years.
After a few iterations on the loan calculator, we find that ABC Co. can borrow an additional $123,500 and meet the lender’s required DSCR of 1.25.
However, if the lender were willing to reduce the interest rate to 8%, the company would be able to borrow an additional $134,500 and still meet the lender’s required DSCR of 1.25.
How Much Could a Company Borrow if the Terms Were Shorter?
Now suppose ABC Co.’s lender was only willing to extend the loan repayment terms for 7 years. How would that change the amount the company could borrow?
At 10% interest payable over 7 years, we find from a few iterations with the loan calculator that the company would only be able to borrow an additional $98,400 to stay above the lender’s minimum DSCR of 1.25.
As you can see from these calculations, the amount of money that a company can borrow based on their monthly payments depends on the lenders’ required DSCRs, the interest rate and the time for repayment. There isn’t a single answer for the amount of money that a company can borrow.
So, What Else Does the Lender Consider?
The DSCR isn’t the only metric that lenders look at when deciding how much to lend a company.
Here are the other factors lenders will consider:
Lenders will look at the credit scores of both the owner and the business. Higher credit scores allow the lender to be more generous with interest rates and repayment terms. These more favorable terms could allow the business to borrow higher amounts of money and still stay within the lender’s required DSCR.
The stability or fluctuations of a company’s cash flow are a consideration of how much debt and monthly payments a company can handle. Businesses with wide swings in cash flow may have difficulty meeting their monthly debt obligations when cash flow drops. Lenders will compensate for this cash flow uncertainty by requiring higher debt service coverage ratios.
Age of Business
Businesses that have been operating for a number of years will have a more stable and predictive future, which will allow the lender to finance for a longer number of years and maybe even relax the DSCR requirement a little.
Lenders don’t want to take possession of the loan’s collateral, but they do have to consider the worst-case scenario if the borrower defaults on the loan payments. Therefore, the quality of the collateral and the ability to resell it to recoup some of these funds is a significant consideration for the lender. For example, financing electronic equipment over longer terms has the added risk of obsolescence and being worth less if the lender has to take possession and resell it.
Certain industries are riskier to finance than others. For example, utilities have highly predictable cash flows and are able to take on higher debts. Lenders have a high degree of certainty that they are going to receive their loan payments. Retail stores, on the other hand, are subject to seasonal fluctuations, intense competition and rapidly changing fashion trends.
Lenders will compensate for these increased risks by reducing the borrowing capacity of the companies.
In addition to the DSCR, lenders also will consider the amount of debt a company has relative to its shareholders equity. Typically, lenders don’t like to see high amounts of debt with small amounts of equity. When that happens, lenders will try to offset the increased risks by requiring higher DSCRs.