How to find your debt-service coverage ratio
If you understand basic division, you can calculate your debt-service coverage ratio (DSCR). Presented by Chase for Business.
Maybe you’re already familiar with the debt-service coverage ratio, or DSCR. If not, it’s worth learning about because you can use it to prove that your finances are in order.
Finding your DSCR — which is the measure of your business’s cash flow versus its debt obligations — is helpful for several reasons. First, it can help you evaluate your business’s finances. By understanding your DSCR, you can identify what you’re currently doing well while also identifying areas for improvement.
Second, if you’re looking for a business term loan to purchase new equipment, increase working capital to expand, make facility improvements, finance owner-occupied real estate, refinance existing debt or acquire another business, having a strong DSCR may improve your chances of being approved for the loan.
And third, you can look for ways to boost your DSCR before you apply for a term loan to try and secure more favorable terms, including higher loan amounts, longer repayment timelines and lower interest rates.
How to calculate your debt-service coverage ratio
To find your DSCR, you’ll need to divide your net operating income by your debt service, including principal and interest. Let’s break those terms down a bit more to clarify what they mean:
Net operating income: This is your company’s gross income minus its operating expenses (e.g., cost of goods sold, taxes, rent or lease payments, equipment, parking, amortization and interest in a given period). The number is always pre-tax and does not include capital expenditures made to acquire or maintain fixed assets. It’s different from your company’s EBITDA (or earnings before interest, taxes, depreciation and amortization).
Debt service: This is the amount of cash needed to pay the required principal and interest of a loan during a given period.
Once you’ve determined your net operating income and debt service, you can begin to calculate your DSCR.
Let’s say, as an example, that your net operating income is $1 million, and your debt service is $200,000. $1,000,000 divided by $200,000 is 5. With a DSCR of 5, you can cover your existing business loan debt five times over with your current net operating income.
What’s a good DSCR, anyway?
When you calculate DSCR, a higher number is better since it indicates more latitude to cover debts and shows a business is in a better position to cover the repayment of a loan. A DSCR of less than 1 means a business’s cash flow can’t cover its debt obligations and reliably repay outstanding debts.
A DSCR of 1 means a business has exactly enough net operating income to cover its debt obligations. There is no universal standard for what constitutes a “good” debt-service coverage ratio, but lenders have specific requirements relative to what they are looking for in a loan candidate.
How to improve your DSCR
Want a higher DSCR? You’ll either need to up your income or cut your debt. The exact tips and strategies for doing that will depend on your industry. Generally, though, approaches to improve the debt-service coverage ratio include the following:
Negotiating better contract terms: To bring down your net operating expenses, you could try to negotiate lower prices and better terms on things like raw materials or shipping or by changing vendors entirely.
Reducing interest rates and payments: If possible, consider refinancing existing loans for a lower interest rate or longer amortization period to reduce monthly payments.
Paying off business loans: Pay off some of your existing debt, if possible, to reduce the amount of debt owed overall.
Working with a financial professional: Financial professionals can help businesses evaluate their financial statements, including profit and loss statements, cash flow statements and balance sheets. Their analysis can help identify additional ways to improve net operating income, such as by boosting gross income and lowering operating expenses.
What to do next
Improving your DSCR by paying off debt can give you a solid foundation to focus on big picture business growth. If you want to talk about ways to strengthen and scale your business, reach out to a Chase business banker today. We’re always ready to help.