For business owners seeking financing, understanding key financial measures like the Debt Service Coverage Ratio (DSCR) is essential. This important ratio shows whether your business brings in enough income to cover its debt payments, which is something lenders want to know before they approve loans. Here, we’ll break down what DSCR is, how it’s calculated, and why it matters for your business.
What is the Debt Service Coverage Ratio (DSCR)?
The Debt Service Coverage Ratio (DSCR) measures a business’s ability to make its debt payments, both principal (the loan amount) and interest, from its operating income. Lenders use DSCR to assess how likely a business is to meet its loan payments. A higher DSCR means the business is in a better position to make these payments, while a lower DSCR may indicate financial strain.
In simple terms, DSCR shows whether your business income can cover its debt payments. A DSCR of 1 means that your income exactly matches your debt obligations. A DSCR above 1 provides a buffer beyond these payments, while a DSCR below 1 suggests that your business may struggle to make debt payments without relying on other funds.
Why Lenders Use DSCR
Lenders use DSCR as a quick way to check if a business can meet its debt payments. If your DSCR is high, it suggests your business generates enough cash flow to cover its debt comfortably, making you a lower-risk borrower. Many lenders set a minimum DSCR requirement, often around 1.25, meaning the business needs to make at least 1.25 times its debt service in income to be considered financially sound.
How to Calculate the Debt Service Coverage Ratio
To work out DSCR, you need two main figures: your business’s net operating income and its total debt service. The formula is:
DSCR = Net Operating Income / Total Debt Service
Here’s what each part means:
- Net Operating Income (NOI): This is your business’s earnings before interest, tax, depreciation, and amortisation (EBITDA). In other words, it’s the income your business makes after covering all operating expenses but before paying interest, taxes, and other costs.
- Total Debt Service: This is the total amount of debt payments (both principal and interest) that your business has to make over a period, typically a year.
Example of a DSCR Calculation
Imagine your business has an annual EBITDA of £150,000, and its total debt service is £100,000. The DSCR calculation would look like this:
DSCR = £150,000 / £100,000 = 1.5
This DSCR of 1.5 means your business earns 1.5 times the amount needed to meet its debt payments. Generally, this is a positive position, as it shows you have a healthy buffer above the minimum requirement of 1.25 set by many lenders.
What Your DSCR Means
Understanding your DSCR helps you gauge your business’s financial health and its readiness for more borrowing. Here’s a guide to different DSCR levels:
- Above 1.25: Your business is likely in a stable position, with enough income to cover debt payments comfortably. Many lenders would consider this a strong DSCR.
- Exactly 1.00: Your business makes just enough to cover its debt payments. This suggests stability but leaves little room for unexpected costs or a drop in income.
- Below 1.00: A DSCR under 1 suggests your income does not fully cover your debt payments. This may indicate a higher financial risk and might make it harder to secure further loans without additional support.
Factors that Affect DSCR
Several aspects of your business can impact your DSCR:
- Revenue Fluctuations: Seasonal or irregular income can affect your net operating income. If income falls unexpectedly, it may lower your DSCR, making it harder to keep up with debt.
- Debt Type and Terms: The kind of debt you have, including interest rates and repayment terms, affects your debt service. Higher interest rates or shorter repayment periods can increase debt service costs, reducing your DSCR.
- Operating Expenses: Rising expenses without a matching increase in income will reduce your net operating income and may lower your DSCR.
- Tax Obligations: Although tax costs aren’t directly part of DSCR calculations, high tax expenses can reduce cash available for debt payments, affecting your overall financial position.
Common Adjustments to DSCR
Lenders sometimes make adjustments to DSCR calculations to better match the business’s type and loan needs. Here are some common adjustments:
- Capital-Intensive Businesses: Businesses that rely on high levels of capital investment, such as manufacturing, may see their EBITDA adjusted to account for these ongoing costs. Since these businesses need to spend regularly to maintain operations, lenders may lower EBITDA to reflect this.
- Owner Compensation: In businesses run by owners, the owner’s salary or dividends might be adjusted to show the business’s true cash flow. This adjustment reflects what remains for debt service after the owner’s earnings are taken out.
- Lease vs. Mortgage: If a business recently purchased property that it was renting before, lenders may adjust DSCR to remove historical rent expenses and add in new mortgage payments, giving a more realistic picture of future cash flow.
How Lenders Use DSCR in Loan Agreements
Many loans include DSCR requirements, meaning borrowers must keep their DSCR above a certain level for the loan’s duration. For instance, a lender may require the borrower to maintain a DSCR of at least 1.25. If the DSCR drops below this, it could trigger penalties or even default, depending on the loan terms.
Lenders may also use DSCR as part of their decision-making for new loans. A high DSCR often leads to better loan terms, such as lower interest rates or higher loan limits, as it shows that the business poses less risk.
Comparing DSCR to Other Financial Ratios
While DSCR is important, lenders often look at other financial ratios for a more complete view of a business’s health:
- Interest Coverage Ratio: This measures only a business’s ability to cover interest payments, excluding principal repayments. DSCR is more comprehensive, as it includes both principal and interest, giving a fuller picture of financial fitness.
- Current Ratio and Quick Ratio: These measure a company’s ability to meet short-term liabilities but don’t specifically address debt repayment capacity.
Is DSCR a Suitable Measure for Your Business?
The DSCR is especially useful if your business relies on loans or credit to fund growth or operations. If you’re thinking about taking on more debt, maintaining a strong DSCR can improve your chances of securing favourable terms. Monitoring your DSCR regularly can also help you spot early signs of financial stress and manage debt levels more effectively.
To calculate your DSCR accurately, you’ll need detailed financial records, including income statements and loan details. Consulting with a financial advisor may also help you understand any specific adjustments that might apply to your business.