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What is the debt service coverage ratio?
DSCR is the cash your business has available for debt payments divided by the total of all its debt payments. A ratio of 1.0 means you only just cover your debts; above 1.0 means there is a cushion. Many lenders prefer to see a ratio comfortably above 1.0, often around 1.25 or higher, though requirements vary.
When a lender looks at your application, one question sits underneath all the others: after paying your normal costs, is there enough cash left to make this new payment as well as the ones you already have? The debt service coverage ratio, or DSCR, is the standard way of answering it with a single number.
The formula
DSCR = cash available for debt service ÷ total debt payments (principal and interest) for the period.
"Cash available for debt service" is, roughly, your operating income before debt payments, with non-cash items such as depreciation added back. Lenders have slightly different definitions, but the idea is the same: what the business earns before it pays lenders, divided by what it owes lenders.
A worked example
Imagine a business that earns $150,000 a year in operating cash flow before debt payments. It currently pays $60,000 a year on existing loans and wants a new loan that would add $30,000 a year in payments.
- Current ratio: $150,000 ÷ $60,000 = 2.5
- With the new loan: $150,000 ÷ $90,000 = about 1.67
- If operating cash flow fell by 20% to $120,000: $120,000 ÷ $90,000 = about 1.33
Even after the shock, the business still covers its debts. A lender would likely be comfortable. If the same business earned only $100,000, the ratio with the new loan would be about 1.11, which leaves little room, and a lender may ask for a smaller loan or a longer term.
What ratio do lenders want?
Requirements differ by lender, product and industry, so treat any figure as a guide. A ratio below 1.0 means the business does not generate enough to cover its debts. A ratio just above 1.0 leaves almost no margin. Many lenders look for more cushion, with a ratio of around 1.25 or higher a common benchmark. Alternative lenders often focus more on recent bank deposits than on a formal ratio.
How to improve your DSCR
- Raise cash flow: improve margins, reduce waste, collect receivables faster
- Lower payments: extend the term, or refinance expensive short-term debt into a longer loan (see refinancing a business loan)
- Borrow less: a smaller loan means smaller payments
- Pay down existing debt: especially high-payment, short-term products
- Separate owner draws: if the owner takes a lot out of the business, lenders will account for it
Where DSCR fits with everything else
DSCR is one input alongside credit, time in business, collateral and the purpose of the loan. A strong ratio can offset a mid-range credit score, and a weak one can undermine an otherwise strong application. See how to qualify for a term loan for the full picture.
Common mistakes
- Forgetting existing payments when working out the ratio
- Using an unusually good month instead of a typical year
- Ignoring seasonal dips that a lender will see in your statements
- Counting owner draws as profit retained in the business
