Factors such as your credit history, business assets and debt service coverage ratio play an important role in helping lenders decide whether you’re a risky investment or not — but it’s impossible to know which factor a lender will care about the most. Learn what a debt service coverage ratio, or DSCR, is and why it’s important in our guide below.
What is the debt service coverage ratio?
The debt service coverage ratio (DSCR) — also called a debt coverage ratio (DCR) — is an industry measure of the cash income a business has leftover at the end of the month that can be used to service its debt (including principal, interest and lease payments).
A high DSCR means you have a substantial amount of money leftover at the end of the month after all of your expenses have been payed – money you could put towards loan repayments if you got a new loan. A low DSCR means you’re just barely meeting your expenses by the end of the month, with very little money leftover
How does your DSCR impact your loan eligibility?
Any time you apply for a loan at a bank or any other traditional financial institution, the lender will use your DSCR to decide whether your business will be able to manage its repayments. The higher your debt service coverage ratio, the better.
Simply put, the DSCR is one of the main benchmarks used to determine your ability to make repayments. If your business isn’t generating the income it needs to pay its debt and make repayments – meaning your DSCR is low – then a lender will likely decline your loan application.
How do lenders view your debt service coverage ratio?
Your business’ DSCR is immensely important to the process of applying for a business loan. Although other factors such as credit history, time in business and loan collateral will be considered as part of your loan application, if your ratio is too low, you’ll likely be denied for the loan altogether.
In general, a ratio of 1.2 is the minimum debt service coverage ratio that a lender is willing to accept. However, depending on the type of industry your business operates in, your lender may have a higher or lower minimum ratio.
How do you calculate your debt service coverage ratio?
To calculate your debt service coverage ratio, use the following calculation:
Your debt service coverage ratio (DSCR) = Annual business operating income ÷ Total annual debt service level (principal and interest you must repay in a given year)
Lenders may use different figures when assessing your operating income. Some will use EBITDA (earnings before interest, taxes, depreciation and amortization), while others will add net operating income to depreciation and any other non-cash charges. As a result, the DSCR figure won’t be the same across all lenders, which can make direct comparison difficult. Some also express the DSCR as a percentage rather than a ratio.
Working out your debt service coverage ratio
To illustrate how the DSCR works, let’s assume your business has a total annual net operating income of $80,000 and you’re applying for a loan with an annual debt service of $30,000 (including annual interest payments). Let’s say you also already have a long-term loan you’re currently paying off at $40,000 of annual debt service.
So, you’ll need to factor in both the loan you’re applying for and the loan you already have – bringing your total annual debt service to $70,000. To calculate your DSCR, take your annual net operating income of $80,000 and divide it by your annual debt service of $70,000.
DSCR = Annual business operating income ÷ Total annual debt service level (principal and interest you must repay in a given year)
DSCR = $80,000 ÷$70,000
DSCR = 1.14
This would equal a DSCR of 1.14, a low ratio that would likely prevent your application from being accepted. This essentially means you’d have $1.14 to pay off every $1 you’d owe in debt – which means you’d be leftover with $0.14 after paying every $1 in debt.
Keep in mind that if you’re able to use future financial projections to convince the lender that your second loan would increase your income/profits to boost your DSCR enough, then you could be accepted.
Bottom line
You should always be careful of getting into too much debt, whether it’s personal or business related. But when your business is in need of cash, being fully aware of the debt service coverage ratio and how it factors into the decision-making process of a lender will help better prepare you when applying for a business loan.
Frequently asked questions about DSCR
Yes, lenders typically look at the business owner(s) personal credit score instead of the business’s credit score. If you have a low personal credit score, it’ll be difficult to get approved for a business loan — and if you do, you’ll likely be offered a higher interest rate. If you’re worried about your credit score, consider rebuilding your credit score before applying for a loan.
Not necessarily. Unsecured business loans are available for some borrowers, but may be difficult to get if you have bad credit or a low DSCR. You can typically only borrow up to $50,000 with an unsecured business loan as well, so if you need to borrow more, you’ll likely have to offer up collateral.
The only way to raise your debt service coverage ratio is to either make more money or pay down your current debts.
Elizabeth Barry is Digital Managing Editor for Entertainment at Are Media and formerly the lead editor for Finder's global financial niches which includes banking, crypto and investments. She has written about finance for 10 years and is regularly featured in a range of publications and media including Seven News, the ABC, MSN, the Irish Times and Singapore Business Review. See full bio
Elizabeth's expertise
Elizabeth has written 4 Finder guides across topics including:
Emma Balmforth is a producer at Finder. She is passionate about helping people make financial decisions that will benefit them now and in the future. She has written for a variety of publications including World Nomads, Trek Effect and Uncharted. Emma has a degree in Business and Psychology from the University of Waterloo. She enjoys backpacking, reading and taking long hikes and road trips with her adventurous dog. See full bio
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