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The debt service coverage ratio (DSCR) is an important metric for small business owners that measures the company's ability to pay its debts. Keeping track of your DSCR can help you gauge how financially sound your business is, as well as your eligibility for financing options.
Whether you're just starting out or your business is well established, here's what you need to know about your DSCR and how to improve it.
What Is Debt Service Coverage Ratio?
The DSCR can tell you whether your business has enough money to pay its financial obligations with its net operating income. If you're a real estate investor, you may apply the DSCR to individual income-producing properties you own.
If you have a DSCR of less than 1, it means that you don't have enough income to cover your debt payments. If your DSCR is higher than 1, however, that indicates you have sufficient funds to pay what you owe and then some.
How to Calculate Your Debt Service Coverage Ratio
To calculate your DSCR, simply divide your annual net operating income by your total debt payments for the year. Your net operating income can be calculated by taking your revenue and subtracting your operating expenses.
| Debt Service Coverage Ratio (DSCR) Formula |
|---|
| DSCR = Net Operating Income / Total Debt Payments |
Debt Service Coverage Ratio Example
To calculate your company's DSCR, you'll start determining your annual net operating income and add up your total debt service payments for the year. Then, you'll divide your net operating income by your total debt payments.
For example, let's say your business has the following financials:
- Revenue: $250,000
- Cost of goods sold: $75,000
- Operating expenses: $125,000
- Principal payments: $25,000
- Interest payments: $10,000
To calculate your DSCR, you'll follow these steps:
- Calculate your net operating income. Add up your cost of goods sold and operating expenses to get $200,000. Then, subtract that from $250,000, giving you $50,000.
- Add up your debt payments. Add up your total principal and interest payments to get $35,000.
- Determine your DSCR. Divide $50,000 by $35,000, giving you a DSCR of 1.43.
Why is Your DSCR Important?
Your DSCR is a crucial metric for your small business, especially if you want to expand. Here are some of the reasons why it's important to have a healthy debt service coverage ratio:
- Ability to qualify for favorable financing terms: As a small business owner, you'll typically need a DSCR of 1.1 or higher to get approved for a bank loan, which typically comes with better terms than an online loan. If you're applying for an SBA loan, the minimum is 1.25.
- Options for real estate investors: Some commercial real estate lenders offer a specialized type of loan called a DSCR loan, which is primarily based on the DSCR of the property in question rather than the investor's income. That said, DSCR loans may require higher down payments and charge higher interest rates.
- Financial flexibility: Having a DSCR above 1 means that your business still has money left over after paying its expenses and obligations. You can use this cash to pay down debt, expand your business or take more profits for yourself.
How to Improve Your DSCR
Because the DSCR is a simple formula with few variables, the steps to improve it are relatively straightforward. If your business is looking to improve its ability to pay its debts, here are some steps you can take:
- Increase your revenue. Look for opportunities to increase your revenue by expanding your customer base, increasing your prices or offering additional products or services.
- Reduce your expenses. Consider different ways you can cut back on your operating expenses. Options may include negotiating lower prices with your suppliers, streamlining your operations to root out waste and finding ways to reduce your overhead costs.
- Refinance your debt. If you have high-interest loans, shop around and see if you can qualify for better terms—a lower interest rate or an extended term can lower your monthly payments. This can be particularly useful if you've taken steps to build your business credit history since you first took out the loan.
- Pay down your debt. If you have a DSCR above 1, consider using some of your extra income to pay off smaller balances and eliminate those payments from the DSCR calculation.
What's the Difference Between DSCR and Debt-to-Income Ratio?
Both the DSCR and the debt-to-income ratio (DTI) are used to indicate the ability of a business or household to manage its debt, and lenders may use one or the other to evaluate your creditworthiness. Beyond that, however, there are some key differences in their purposes and calculations.
More specifically, the DSCR is primarily used for business and commercial real estate purposes, while the DTI is a personal finance metric. For example, if you're applying for a mortgage loan for your primary residence or an auto loan, lenders will calculate your DTI.
There's also a difference in the formulas. While the DSCR shows a business owner whether they have sufficient income to pay their debts on an annual basis, the DTI indicates how much of an individual's gross monthly income goes toward debt payments. Here's a quick summary of how the two metrics differ:
| Debt Service Coverage Ratio vs. Debt-to-Income Ratio | |
|---|---|
| Debt Service Coverage Ratio | Debt-to-Income Ratio |
| Used by businesses and real estate investors | Used by individuals |
| Calculated by dividing your annual net operating income by your debt payments | Calculated by dividing your total monthly debt payments by your monthly gross income |
| Shows whether a business has sufficient income to satisfy its debts | Shows whether an individual has too much debt relative to their income |
| May be a stipulation for business financing and commercial real estate loans | May be a stipulation for consumer loans |
What Is a Good Debt Service Coverage Ratio?
At a minimum, small business owners should want a DSCR of 1 or above because it means that they have enough net operating income to pay their creditors. However, it's best to target a DSCR of 1.25 or higher.
The higher your ratio is, the easier it will be to qualify for financing when you need an injection of capital, and the more flexibility you'll have overall.
Keep in mind, though, that if your DSCR is too high, it could mean that you're not using your cash flow efficiently or that you're not taking advantage of expansion opportunities. If your DSCR is high, consider ways you can leverage low-interest debt to expand your business.
The Bottom Line
If you're a small business owner or real estate investor, keeping track of your company's or property's DSCR can help you better understand your relationship with debt. However, it's just one of many metrics to ensure proper money management.
In many cases, for instance, small business and commercial real estate lenders may require a personal credit check when you apply for a loan. As a result, it's important to also keep track of your credit score. With Experian's free credit monitoring service, you'll get access to your FICO® Score☉ and Experian credit report, along with real-time alerts when changes are made to your report.