Sara owns a thriving restaurant, and she thinks the time is right to expand.
Specifically, she wants to expand the catering and food truck side of her business because she sees the most growth potential in this area.
It will also be cheaper and easier than moving her lunch and dinner business to a larger location or opening a second location.
However, Sara doesn’t have enough capital to expand on her own, and she wants to understand how lenders will evaluate her business before she applies for a loan.
A key metric that lenders will judge her ability to repay a loan by is the debt service coverage ratio, or DSCR.
Let’s look at how lenders calculate this ratio and what it tells them.
What is Debt Service Coverage Ratio?
The debt service coverage ratio compares a business’s annual net income against its existing and proposed annual debt payments.
Debt Coverage Ratio Formula
At a glance the DSCR formula looks like this:
Annual Net Operating Income + Depreciation/ Interest + Current Maturities of Long-Term Debt
This ratio shows how easily a company will be able to make its debt payments given its income and expenses.
If the ratio is greater than 1.00, it means the company has more than enough net income to make its debt payments.
For example, a ratio of 1.30 means the business makes 30% more than it needs to make its debt payments.
If the ratio is less than 1.00, it means the company doesn’t have enough net income to make its debt payments.
For example, a ratio of 0.90 means the business makes only 90% of the income it needs to pay its debts.
If the ratio is equal to 1.00, it means the company has exactly enough net income to make its debt payments.
Most companies’ debt service coverage ratios fall between 0.00 and 2.00.
How to Calculate Debt Service Coverage Ratio
To calculate the DSCR, you’ll need to know how lenders will calculate your business’s annual net income and how they will calculate your annual debt payments (also called debt service, hence the name “debt service coverage ratio”).
Let’s look at annual net income first.
Net income is the revenue your company has left after subtracting its net operating expenses.
Take Sara’s restaurant, for example.
Her revenue consists of all the money she earns from selling lunch and dinner to customers plus her catering revenue.
Lunch revenue: $120,000
Dinner revenue: $200,000
Catering/food truck revenue: $80,000
Total annual revenue: $400,000
To calculate net revenue, we need to know what Sara’s operating expenses are.
A restaurant has numerous operating expenses, so for simplicity’s sake, we’ll include only a few major categories in our example.
**These numbers are for basic illustrative purposes and may not represent the actual economics of running a restaurant.
Workers’ wages: $140,000
Owner’s salary: $40,000
Cost of food: $120,000
Sales taxes: $40,000
Federal income taxes: $20,000
Total operating expenses: $380,000
Now that Sara knows her total operating expenses, she needs to know her net operating income.
For the purpose of calculating her DSCR, lenders don’t include interest or income tax in total operating expenses.
So rather than subtracting total operating expenses of $380,000 from $400,000 in annual revenue, they will subtract total operating expenses of $360,000 because they won’t count Sara’s $20,000 in income taxes.
Sara doesn’t have any existing loans.
That gives her $40,000 in net operating income.
Sara wants to borrow $100,000 to purchase a second and third catering truck and she wants to make about $20,000 in annual loan payments, including interest.
To calculate her debt service coverage ratio, Sara divides her $40,000 in net operating income by her $20,000 in annual loan payments to get a ratio of 2.00.
With such a high DSCR, Sara will have a very good chance of securing a loan with favorable terms, assuming she also has a good credit score.
What Debt Service Ratio Do Lenders Require?
It might seem like a debt service ratio of 1.00 would be sufficient to get approved for a loan, but it’s not.
If a business with a DSCR of 1.00 has even the slightest decrease in income or increase in expenses, its debt service coverage ratio will drop below 1.00.
The business won’t have enough money to make all of its debt payments if either or both of those things happen.
That’s why having a debt service coverage ratio of 1.25 or higher is what most lenders are looking for.
It means the business has a significant cushion to handle any financial hiccups and still meet its loan obligations.
Maintaining Your Debt Service Coverage Ratio
Lenders will expect Sara to maintain a minimum debt service coverage ratio for the duration of the new loan term.
So it’s important that Sara expects her business’s expenses and income to remain stable or to increase proportionally, or that she expects income to rise faster than expenses.
If the new lender learns that Sara’s DSCR has fallen below its minimum requirement, the lender could call the loan due, meaning that Sara would have to repay the entire remaining balance within 90 to 120 days—
A potentially disastrous situation.
After all, Sara has likely taken the loan proceeds and invested them into the business, and she’s not anticipating making a large, lump-sum payment anytime soon; she’s only prepared to make her scheduled monthly payments.
She might have to lay off an employee, cut her own salary, or make other drastic changes to afford to repay the loan.
In a worst-case scenario, she might go out of business or have to sell her company.
And becoming delinquent on loan payments would damage her credit score, making it more difficult to borrow in the future.
Check out How to Get a Good Loan with Bad Credit for what to do if you find yourself in this situation.
The lender might only ask to see the debt service coverage ratio annually, but Sara will want to stay on top of it monthly so she can make any adjustments as needed.
If she notices that her DSCR is declining, she can seek refinancing or loan modification to avoid having the loan called.
Varying Lender Requirements for Debt Service Coverage Ratio
Different lenders have different minimum requirements for debt service coverage ratios, so you should ask prospective lenders what ratio they require before you apply so you don’t waste time applying with a lender that requires a ratio you can’t hit.
When you ask about minimum ratio requirements, you also need to ask how the lender will calculate your DSCR.
Despite how straightforward the calculation looks in the example above, some lenders vary their calculations.
They might exclude depreciation and amortization expenses, the owner’s salary, and/or any other one-time expenses.
Why might a lender add the owner’s salary back in?
Because some owners maximize their compensation in order to minimize their net profit if it will lower their income tax liability.
Economic conditions can also affect the minimum DSCR that lenders require.
In a strong economy, they may be comfortable lending to companies with debt service ratios on the lower side since business can be expected to continue at a brisk pace.
In a struggling economy, however, lenders may be worried about whether a business will be able to maintain its income, and they might require a higher debt service coverage ratio to reduce the risk that they won’t get repaid.
Getting Approved for a Loan When Your Debt Service Coverage Ratio Is Too Low
There are lenders that specialize in lending to businesses with a debt service coverage ratio below 1.00, though they will typically draw the line at 0.50 to 0.70.
Is cash tight? Check out How To Start A Business With No Money – Bootstrapping Your Startup
There are also circumstances where a lender might consider a ratio below 1.00 to be acceptable.
These circumstances include
- fast-growing companies that are on track to be profitable but are currently reinvesting their profits in the company
- projects where the loan revenue will clearly and substantially increase future income
- or refinancing short-term debt to a longer term and/or lower interest rate– thereby increasing the company’s cash flow and its debt service coverage ratio.
For example, if a business can show that the increased net revenue it will be able to generate with the loan proceeds will boost its DSCR well above 1.00, it might be able to get a loan.
If your company alone does not have an ideal debt service coverage ratio and doesn’t fall into one of the above categories, consider working with a lender who will consider other sources of personal income besides your business income to calculate what’s called a global debt service coverage ratio (as opposed to a company-specific debt service coverage ratio, which is what we’ve been discussing in this article).
The global debt service coverage ratio also takes personal debts into account, such as mortgage payments, credit card payments, and auto loan payments, so this strategy will only work for a business owner who has substantial outside personal income and minimal personal debt.
Some lenders look at both ratios to get a more complete picture of the borrower’s financial situation.
Improving Your Debt Service Coverage Ratio
What could you do if you couldn’t find any lender that would accept you current debt service coverage ratio?
You would need to either increase your business’s income, decrease its expenses, or both, and you would need to do so in a way that you could sustain for the next three years.
If you owned a restaurant, like Sara, perhaps you could bump up the price of your most popular menu items by $1 to $2 apiece or consolidate your food purchases among fewer suppliers to obtain a volume discount — or both.
You could also apply for a smaller loan or a longer loan term.
Lenders don’t just care about a business’s debt service coverage ratio at the moment the business owner applies for the loan; they also care about what it will look like for a few years into the future and sometimes a few years into the past.
Stability or steady improvement is key.
Debt Service Coverage Ratio – What It Means For You
A company’s debt service coverage ratio is a key metric that lenders use to decide whether to extend a loan.
It shows whether the company has enough net income to coverage its annual debt service, including the loan it’s applying for, and to withstand any decreases in net income or increases in operating expenses.
Most companies have a DSCR between 0.00 and 2.00; most lenders require a minimum ratio of 1.25 to 1.50 to qualify for a loan.
Some lenders calculate debt service ratios in ways that may be more favorable to the business, and some lenders will work with businesses with low DSCRs — under the right circumstances.
Further, a business that doesn’t qualify with one lender may qualify with another, and terms can vary, so as with any loan, it’s important to shop around.
Whether you’re looking at a traditional term loan, a personal loan for business, an equipment loan or another type of small business loan, lenders will strongly consider the debt service income ratio–
It can make or break your application.
But the loan application process doesn’t have to be one-sided anymore.
These days, you have options.
For best results, work on your debt service coverage ratio, then compare multiple loan offers to nab the best deal.