If you run a small business and are looking for funds to strengthen or grow that business, the DSCR may be the most important number you aren't currently thinking about. Before a bank will lend you any money, they need to make sure you can pay them back. That's where your DSCR or Debt Service Coverage Ratio, a measure of whether you have enough money to make loan payments, becomes important. In this post, we’ll explain what DSCR is, how to calculate it, and what lenders consider a good DSCR for small businesses.
📌 This is for informational purposes and not financial advice. Consult with a CPA or accountant for your specific situation
What is the DSCR?
DSCR stands for Debt Service Coverage Ratio. It's like a report card that shows whether you can pay your debts on time. It looks at how much money you have coming in, compared to how much you owe in loan payments.
"DSCR shows how much cash your business generates compared to how much it owes."
The DSCR is different from the debt-to-income ratio (DTI), which is a metric for individuals in personal finance. DTI compares how much someone pays in debts each month to their income. DSCR looks at how much money a business makes compared to how much it owes in loans and so is better for measuring if a business can repay its loans. DSCR is therefore a more comprehensive measure of a business's ability to repay its debts.
To calculate your DSCR, you need to know how much money your business makes (your “net operating income”) and how much money you owe on loans (your “total debt service”). You divide your net operating income by your total debt service to get your DSCR. If your DSCR is higher than 1, it means you should be able to make your loan payments on time. If it's less than 1, it means you might have trouble paying your loan.
How to Calculate Your DSCR
You can calculate your DSCR using a calculator or ask a financial advisor for help. A DSCR of 1.2 or higher is usually seen as a good score to lenders. This means you make 20% more money than you owe in loan payments.
To calculate your DSCR, you need to know your net operating income and total debt service.
- Net operating income (NOI) is your business's revenue minus operating expenses (excluding interest and taxes)
- Total debt service (TDS) is the total amount of debt payments your business makes in a given period (including principal and interest).
Once you have these figures, you can calculate DSCR using the following formula:
DSCR = NOI / TDS
Let's look at a few examples
Healthy DSCR - Assume a small business has the following financial information for the year:
Total revenue: $100,000
Operating expenses: $60,000
Debt payments: $30,000
To calculate the net operating income (NOI), subtract the operating expenses from the total revenue:
NOI = Total Revenue - Operating Expenses
NOI = $100,000 - $60,000
NOI = $40,000
This means the business generated $40,000 in net operating income for the year.
To calculate the Debt Service Coverage Ratio (DSCR), divide the net operating income by the total debt payments:
DSCR = Net Operating Income / Total Debt Payments
DSCR = $40,000 / $30,000
DSCR = 1.33
This means the business has a DSCR of 1.33, which indicates that they generate 33% more cash than they owe in debt payments. This is generally considered a good DSCR and indicates that the business has enough cash flow to cover their debt payments.
Poor DSCR - assume a small business has the following financial information for the year:
- Total revenue: $100,000
- Operating expenses: $70,000
- Debt payments: $60,000
To calculate the net operating income (NOI), subtract the operating expenses from the total revenue:
NOI = Total Revenue - Operating Expenses
NOI = $100,000 - $70,000
NOI = $30,000
This means the business generated $30,000 in net operating income for the year.
To calculate the Debt Service Coverage Ratio (DSCR), divide the net operating income by the total debt payments:
DSCR = Net Operating Income / Total Debt Payments
DSCR = $30,000 / $60,000
DSCR = 0.5
This means the business has a DSCR of 0.5, which indicates that they owe twice as much in debt payments as they generate in cash flow. This is generally considered a poor DSCR and suggests that the business may struggle to pay off its debts.
How Do Lenders Use the DSCR?
Lenders use the DSCR to assess your business's creditworthiness and loan eligibility. If your DSCR is high, it shows that you have enough cash flow to pay back the loan, which makes it less risky for lenders to lend you money. If your DSCR is low, it means you might struggle to pay back the loan, which makes you a riskier candidate for financing.
When you apply for a loan, the lender calculates your DSCR to see if you can pay back the loan. Lenders usually require a DSCR of 1.2 or higher for small business loans, but this can vary depending on the lender and the industry.
If your DSCR is too low, the lender might not lend you any money, or might offer you a loan with higher interest rates or less favorable terms. If your DSCR is high enough, the lender might offer you a loan with good terms, like a low interest rate or longer repayment period.
Improving your DSCR is important, as it can increase your chances of getting financing with good terms and keeping your business healthy. It’s important for you to monitor your DSCR regularly and take steps to improve it if necessary so you can position your business for long-term success.
How to Improve Your DSCR
If your DSCR is low, there are some things you can do to improve it:
- Increase your revenue: You can generate more cash by increasing sales, expanding your customer base, or introducing new products or services.
- Reduce your expenses: You can lower your operating costs by negotiating better supplier contracts, optimizing your production processes, or cutting unnecessary expenses.
- Refinance your debt: You can reduce your debt payments by refinancing your existing loans at a lower interest rate.
- Postpone large capital expenditures: You can delay large investments in equipment or facilities until your business generates more cash flow.
Get Funding Help for Your Business
Interested in learning more about DSCR, or want more funding for your business? Check out Skip's 1-1 membership options.