Key takeaways
- The debt service coverage ratio measures your business’s cash flow against its debt obligations.
- Lenders use the DSCR to see if you have enough income to repay a loan.
- Although there is no universal standard, most lenders want to see a DSCR of 1.25 or higher.
Debt service coverage ratio (DSCR) is a calculated ratio that indicates your business’s ability to cover its existing debt obligations. Business lenders may use DSCR when evaluating your application for a small-business loan to determine how much new debt your business can afford to take on.
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What is the debt service coverage ratio?
DSCR is a measure of your business’s cash flow against your business’s current debt obligations, or debt service. When evaluating a loan application, this calculated number gives a prospective lender an idea of how much additional debt your business can afford to take on.
What is debt service?
Total debt service refers to the amount of cash your business needs to cover principal and interest payments on all outstanding debt, over a specific period of time. Essentially, it’s a sum of all the debt payments your business currently makes. A business lender may ask you to list these obligations on a business debt schedule.
Different types of lenders have their own requirements for minimum debt service coverage ratio — there is no universal industry standard. That said, a DSCR of 1.25 to 1.50 is a typical minimum for most lenders, while a DSCR of 2.0 would be considered very strong.
Global debt service coverage ratio
Global debt service coverage ratio (GDSCR) refers to the calculation of DSCR including the debt and income of both the business and owner(s). It may either strengthen or weaken the DSCR — if an owner has good outside income and little additional debt, the DSCR should improve, while if they have a lot of personal debt to add, it may have the opposite effect.
A lender may choose to incorporate your personal income, your spouse’s personal income or income from another business if your business DSCR isn’t high enough to stand on its own. This may be especially relevant if the business owner’s salary makes a significant impact on the business’s profits.
Debt service coverage ratio formula
The debt service coverage ratio is calculated by dividing your net operating income (gross income – operating expenses) by your business’s total amount of debt:
DSCR = Net operating income / Total debt service
How to calculate the debt service coverage ratio
Let’s use an example to show how to calculate the debt service coverage ratio. Say, for instance, you have a business with an annual net operating income of $350,000 and $200,000 in outstanding annual debt obligations.
To calculate DSCR, you divide $350,000 by $250,000 to get 1.75:
350,000 / 200,000 = 1.75
A DSCR of 1.75 means your business has 1.75 times the cash it needs to cover current debt obligations. In other words, your business has $1.75 in cash for every dollar of outstanding debt.
» MORE: Calculate your own DSCR with our free DSCR loan calculator.
Why is DSCR important?
DSCR is a relatively simple calculation that can help you monitor the financial health of your business. Having an idea of your business’s ability to cover current debt can help you understand its ability to scale and plan strategically for growth. It’s similar to understanding and monitoring debt-to-income ratio (DTI) for your personal finances.
It’s particularly important to understand DSCR before applying for a loan. Small-business lenders use DSCR during the loan application process to get an idea of how much new debt your business can afford.
How to improve your debt service coverage ratio
By nature of the formula, your debt service coverage ratio will improve if you work on the two numbers that factor into it — i.e., if you increase your net operating income and decrease your debt obligations.
To boost net operating income, business owners may consider revisiting vendor contracts to negotiate better terms or prices, look at expenses to cut or pursue new contracts or clients. Paying down as much debt as possible, as well as refinancing current debt at lower interest rates can help reduce debt obligations.
Frequently asked questions
What is a good debt service coverage ratio?
There is no universal standard for DSCR; however, most lenders want to see at least a 1.25 or 1.50. A DSCR of 2.0 is considered very strong.
Who uses debt service coverage ratio?
Business lenders use debt service coverage ratio when deciding to approve a business loan. The number helps them understand how much additional debt your business can afford to take on.
Why does debt service coverage ratio matter?
Debt service coverage ratio gives an indication of how well your business is covering its current debt obligations. It’s important to understand the financial health of your business, and lenders use it to determine if your business is able to take on more debt. A high DSCR can be an important factor in your business getting approved for funding.
