Is your business financially fit? Your debt-service coverage ratio can tell you

 

Your debt-service coverage ratio (DSCR) measures your company’s ability to pay its debts. It divides your net operating income (revenue minus operating expenses) by your total debt obligations like loan payments and interest. Over time, tracking your DSCR can give you insight into the financial health and growth potential of your business. Essentially, a solid DSCR is like a badge of smart money management and growth potential.

 

How does DSCR work?

Think of a DSCR as a way to measure whether your business has enough money to cover its bills. To lenders, a higher DSCR signals a lower risk, because it means a borrower can more easily handle their debts.

And it isn’t just for businesses. In terms of personal finances like buying a house, mortgage lenders might use a DSCR as one way to determine whether someone can juggle a new loan along with what they already owe. Governments use DSCRs as well, especially when they need to show they’re financially stable enough to take on big projects or manage public funds.

But your DSCR is more than just a set of numbers. As a business owner, it’s also the story of your company’s financial success. It reflects your ability to operate your business well and manage a stable cash flow.

 

The benefits of a good DSCR

For a business, especially a small one, knowing your DSCR is crucial when you want to borrow money. Keep in mind that different industries have different DSCR standards. For example, service industries like restaurants and breweries often have higher DSCRs, while professional services like accounting or legal firms sometimes have lower ratios.

Whatever industry you’re in, banks and lenders will look at your DSCR to determine whether you can pay back a loan. They usually want this ratio to be more than 1.00, meaning that you can pay your debt and then some.

That said, your DSCR doesn’t exist in a vacuum. It can tell a different story depending on how the overall economy is doing. In good times, higher profits can boost your DSCR. In a downturn, things get tighter and your DSCR might dip, making banks more cautious about lending.

Banks often want to see a DSCR of at least 1.25, because that shows a business has the working capital it needs to operate plus some extra financial cushion — it isn’t just scraping by. More importantly, the higher ratio gives banks some confidence that the business can handle unexpected costs or downturns without missing a debt payment.

The minimum DSCR can be different for other types of lenders. For example, the U.S. Small Business Administration (SBA) looks for a DSCR of at least 1.15 to approve a loan. While lower, this score still indicates that you’re able to run your business effectively while you repay the loan.

To get a better idea of what all this means, let’s look at a fictional company called Small Town Brewery.

 

A solid DSCR in action

Small Town Brewery calculates its DSCR by taking its net operating income (remember, that’s all the money the business makes minus the costs of running it) and dividing it by its total debt service (all the money it owes). It comes up with the following numbers:

Small Town Brewery cash flow

Quarter ended June 30

• Revenue from beer sales: $750,000
• Cost of goods sold: – $200,000
• Operating expenses: – $50,000
• Net operating income: $500,000

• Loan principal payments: $200,000
• Loan interest payments: $100,000
• Total debt service: $300,000

• DSCR (Net operating income ÷ Total debt service)
• $500,000 ÷ $300,000 = 1.67

 

Thanks to strong sales growth and lean operations, our fictional local brewery has built a net operating income of $500,000 against $300,000 in debt service. Its solid DSCR of 1.67 helps the business qualify for an SBA loan to expand distribution.

 

The problem with a low DSCR

If your DSCR is on the low end, you might be in a financial squeeze. Consider the financials of another fictional company, Main Street Legal Services:

Main Street Legal Services cash flow

Quarter ended June 30

• Legal services revenue: $300,000
• Operating expenses: – $150,000
• Net operating income: $150,000

• Loan principal payments: $150,000
• Loan interest payments: $50,000
• Total debt service: $200,000

• DSCR (Net operating income ÷ Total debt service)
• $150,000 ÷ $200,000 = 0.75

 

With a tight DSCR of 0.75 — below the 1.00 safety line — Main Street Legal has struggled to get the financing necessary to expand because the business isn’t able to fully cover its debts. It’s short by 25%.

 

Use your DSCR to guide your business

Understanding your DSCR isn’t just about getting a loan. It’s a smart business move that can help you understand how well you’re managing your money.

Monitoring DSCR over time, like Small Town Brewery does, helps businesses make smart financial decisions. And even Main Street Legal can turn things around. By reducing expenses and focusing on more profitable legal services, the fictional firm can increase its DSCR to a more stable level over the next year.

Your DSCR is a big-picture tool that can open up financing options for your business: better loan conditions, potentially more credit and maybe even interested investors. A good DSCR signals that your business is solid enough to handle day-to-day operations and strong enough to pursue new opportunities.

Want to talk about ways to strengthen your business or grow your company? Reach out to a Chase business banker today. We’re always ready to help.