Debt-service coverage ratio: What is it and how do you calculate it?

In a business context, debt-service coverage ratio (DSCR) is a metric that compares a company’s cash flow against its debt obligations. Business owners and investors can use DSCR to understand if the company is generating enough net operating income to cover existing debts, including principal and interest.

DSCR can help inform future business decisions, including whether a company has the financial ability to repay its existing business loans and take on further debt. It also helps lenders assess the strength of business loan applications and how much risk they’ll take on by lending to you.

How to calculate debt-service coverage ratio

There are two main components in how to calculate DSCR: a company’s annual net operating income and its annual debt service. The formula for determining a company’s DSCR is:

Net operating income / Debt service

So, how do you calculate each of these components? For net operating income, you’ll want to look at the business’s pre-tax revenue minus operating expenses, such as wages, rent and cash taxes, for a given period:

Net operating income = Revenue – Operating expenses

Debt service, on the other hand, is the total of all existing debts owed by the company due in the same period. This should include all interest and principal.

It’s important to note that some lenders and financial professionals use different versions of this formula to calculate DSCR. For example, the Corporate Finance Institute (CFI) outlines the DSCR formula using EBITDA — short for earnings before interest, taxes, depreciation and amortization — in place of net operating income. If you’re calculating DSCR to understand your company’s income vs. debts, make sure to be consistent with the formula you choose.

As an example, let’s say that your business has an annual net operating income of $100,000, with a total debt service of $50,000. In that case, your DSCR would be 2, meaning that you can cover your current debt twice over. Later, we’ll explain what this means — and how you can work on increasing your DSCR if need be.

Why does DSCR matter?

On a basic level, tracking your DSCR lets you understand the financial health of your business. It provides a concrete number — rather than a general idea — to help you assess the gap between how much money you’re bringing in and how much is going toward debt.

For lenders, having a strong DSCR indicates that your business has figured out how to balance revenue generation with debt repayment. If you’re hoping to get a new loan (and favorable terms), it’s essential to prove that you have the resources to pay it back.

What’s a good DSCR?

You want to aim for a higher DSCR rather than a lower one, but lenders will determine their own requirements for what qualifies as a good DSCR. They’ll also take into account things like your industry and company age when evaluating your DSCR as part of a loan application.

Current economic conditions matter, too: Lenders might require a higher DSCR from potential borrowers at times when the economy is rocky, and many businesses are defaulting on loans.

Still, there are some basic things to keep in mind when thinking about what makes a good DSCR. For starters, having a DSCR of 1 shows that all of your net operating income will need to go toward debt. Obviously, that’s not a good sign for your company’s financial health or loan chances.

According to the CFI, most lenders will expect to see a DSCR of at least 1.25, but ideally, closer to 2. A better DSCR — especially paired with other indicators of financial health, such as a high business credit score — may mean a lower interest rate.

How to improve your DSCR

Since your DSCR is all about how your income compares to your debt, you’ll need to work on increasing profits or reducing debt (or, better yet, both) in order to raise your DSCR. Of course, these are areas of your business that you’re likely already focused on, so you may need to take a slightly different approach.

Instead of figuring out how to increase sales, think about how to cut certain expenses. For instance, can you negotiate with vendors to lock in lower prices? Can you trim utility or labor costs? In terms of debt reduction, are you able to refinance your current loans and lock in a lower rate?

The bottom line

Whether you’re preparing to secure another round of financing or you just want to take a better look at your company’s financial well-being, understanding DSCR’s meaning is a useful exercise. If it’s not quite where it needs to be, there are ways to improve it. Start by turning your efforts toward driving revenue while reducing expenses and existing debt.

Frequently asked questions

• What is a good debt-service coverage ratio?

  Most lenders want to see a debt-service coverage ratio of at least 1.25. But, lender requirements will vary depending on the type of business loan and lender you select.

• Is a higher DSCR better?

  Yes, a higher DSCR is better. While a DSCR of 1.25 is the minimum requirement for most lenders, a higher number — such as 2 — shows lenders you are financially stable and can repay your debts. A higher DSCR can also mean a potentially lower interest rate as lenders see you as less of a risk for defaulting on your business loan.

• How can I increase my DSCR?

  To increase your DSCR, you’ll want to look at lowering the amount of debt your business has and increasing profits. If increasing sales is something your business is struggling with, you can look at ways to cut costs in your business’s budget.If you’re having difficulty paying down debt, consider refinancing or consolidating your business loans.