The debt service coverage ratio is often used by lenders to decide whether you are eligible for business loans. I’ll explain how to calculate it, how lenders use it, what a good ratio amount is, and how to improve your DSCR.
How to Calculate the Debt Service Coverage Ratio (DSCR)
The formula for the debt service coverage ratio is EBITDA divided by debt payments. Let’s assume a company has $250,000 of EBITDA in a year. The sum of all their monthly loan payments is $15,000. This could be from one loan or the total of many loans. The annual amount of loan payments is then $180,000 (i.e., $15,000 X 12 months). Their Debt Service Coverage Ratio (DSCR) is calculated as their $250,000 annual EBITDA divided by the $180,000 annual loan payments. Their DSCR is 1.39. I explain below if that’s a good ratio.
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How Lenders Use the DSCR
Lenders will calculate the debt service coverage ratio based on the business’s financial statements or tax return. They will also compute the global debt service coverage ratio. The global DSCR combines the business financials with the owner’s financials. The owner’s financial health can be a strength or liability to the company.
At the banks I worked at, lenders were looking for a ratio of 1.25 or higher, which is consistent with industry norms. A ratio of one means EBITDA equals debt service. The minimum ratio of 1.25 adds a .25 or 25% cushion.
The debt service coverage ratio measures your cash flow and ability to pay. When lenders assess the risk of their loan portfolio, they break losses into two components:
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- The probability of default: How likely is the borrower going to be unable to make their loan payments?
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- The severity of default: If the borrower can’t make their loan payments, how much will we lose?
This ratio measures the probability of default. A low probability of default is more important than a low severity of default. If you don’t have good cash flow, pledging more collateral isn’t going to help you much in getting a loan from a bank.
How to Improve Your Debt Service Coverage Ratio
There are two main ways to improve your DSCR:
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- Decrease Your Debt Payments
Increasing your cash flow takes time. I list many ideas in my cash flow guide.
A quick way to increase this ratio is to reduce the periodic debt payments. Long amortization terms reduce periodic debt service payments. A borrower might be well below a 1.25 DSCR with a 10-year amortization term but well above it with a 25-year amortization term. In other words, longer amortizations allow more borrowers to qualify for larger business loans.
I wish you a high DSCR. I wish you well.
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