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The debt service coverage ratio is a financial measurement used to determine the ability for a company or entity to meet its short-term and long-term obligations. It is calculated by dividing total debt by earnings before interest, taxes, depreciation and amortization (EBITDA). The resulting number must be greater than 1.
While credit ratings and income are key considerations for lenders when considering company loans, another calculation might determine whether or not a loan is approved. The debt service coverage ratio (DSCR) is a metric that assesses your company’s capacity to repay a loan.
The DSCR calculates the difference between your yearly company debt and your annual business revenue. While each lender will have different standards for a DSCR, most company loans and invoice factoring demand a DSCR of 1.25 or higher.
What Is the Debt Service Coverage Ratio and How Do I Calculate It?
The following formula may be used to calculate a DSCR:
DSCR = Debt obligations for the current year / yearly net operating income of the business
- Calculate yearly net operational income for a business: Net income is revenue minus operating expenditures, excluding taxes, interest payments, depreciation, and amortization, which should be brought back in when calculating income, as well as the owner’s compensation and one-time nonrecurring expenses.
- Calculate your current year’s business debt obligations: Add the current year’s loan principle, interest, fees, and lease payments together. Include the estimated payment for the loan you’re applying for. If you’re refinancing a loan, utilize the new predicted payment rather than the previous loan payment amount.
- Subtract current debt payment from net operating income: You now have the DSCR. Please use the calculator provided below.
Example 1: Your company has a $100,000 net operating income. Your debt commitments total $40,000 each year. The DSCR of your company is $100,000/$40,000, or 2.50.
Example 2: Your company has a $50,000 net operating income. Your debt commitments total $75,000 each year. The DSCR of your company is $50,000/$75,000, or 0.67.
Based on the DSCR, your company will most likely qualify for the loan in Example 1. In example 2, however, the loan application will very certainly be declined owing to a DSCR of less than 1.25. Example 2 shows a company that can only satisfy 67% of its present commitments.
What Does the Dodd-Frank Act Mean for My Company?
Lenders often demand that a company’s DSCR be more than 1.25. So, here’s what that figure indicates in terms of your company’s financial health:
- If your DSCR is larger than one, your company has adequate revenue to cover its obligations, plus a buffer in case of cash flow fluctuations. A DSCR of 1.25, for example, indicates that your company earns 25% more than it needs to service its obligations.
- If your DSCR is 1, all of your company’s net revenue will be used to pay down debts. This implies that any decrease in cash flow might create serious troubles for your company.
- If your DSCR is less than one, your company isn’t making enough money to cover its bills. With a DSCR of 0.95, you’re only paying 95% of your company’s obligations. A company owner would have to utilize the personal income to settle the remaining debts. A lender would most certainly see this firm as financially unsound, and any loan applications would be denied.
How Can You Increase Your Debt Service Coverage Ratio?
The improvements that must be made to enhance the ratio are pretty obvious since the DSCR is a straightforward calculation. To enhance a DSCR, a company’s revenues must rise, its costs must fall, or its debts must fall.
While you may grow sales or raise pricing to boost income or pay off debts to reduce responsibilities, these things aren’t always possible to do rapidly. If you want to borrow money in the future, you should monitor your company’s DSCR closely. You may make modest revisions and check that the figure is more than 1.25 before starting the loan application procedure this way.
If your company’s DSCR is on the verge of qualifying for financing, a smaller loan might help lower the debt side of the equation sufficiently to qualify.
The Importance of a High DSCR
You may verify that your DSCR is high enough before asking for credit if you have a sound long-term financial strategy. Another incentive to retain a high DSCR is that many company lines of credit demand yearly financial reporting that includes current revenue and debt information.
If a company fails to maintain a high DSCR over the term of a line of credit, the lender may cut the maximum credit limit or cancel the line of credit entirely. This might seriously jeopardize a company’s financial stability.
Conclusion
The debt service coverage ratio is calculated by dividing your company’s yearly net income by its annual debt commitments. To qualify for loans and maintain financial stability, a company’s DSCR should be more than 1.25. Credit scores are often monitored by business owners. You should, however, keep a careful check on your DSCR. A poor DSCR may be just as damaging to your business as a bad credit score.
