Learn the importance of the debt-service coverage ratio and how it factors into a lender’s decision-making processes.
Applying for loans is common practice for any business and, if done right, can allow your business to grow and increase its profits. You have a better chance of being approved for a loan if you understand the different factors a lender takes into consideration when reviewing your loan application.
Factors such as your credit history and business assets play a leading role in helping lenders decide whether you’re a risky investment or not, but there are also lesser-known factors. Among these is the all-important debt-service coverage ratio (DSCR).
What is the debt-service coverage ratio?
The DSCR – also called a debt coverage ratio (DCR) – is an industry measure of the cash income a business has left over at the end of the month that can be used to service its debt (including principal, interest and lease payments).
Any time you apply for a loan at a bank or any other traditional financial institution, the lender will use the DSCR to decide whether your business will be able to manage its repayments
Simply put, the DSCR is one of the main benchmarks used to determine your repayment ability. If your business isn’t generating the income it needs to service its debt and make repayments, then the lender will likely pass on your application.
Generally, mainstream and traditional lenders will usually have a DSCR minimum of 1.2 or more. However, this may be a bit higher or lower depending on the general health of the economy, the particular lending institution and other factors. Nonetheless, the higher your debt ratio, the more likely it is that a lender will accept your application.
How do you calculate it?
The usual way to calculate the DSCR is by dividing your annual business operating income by your total annual debt service level (the amount of 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 amortisation); 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 lenders, which can make direct comparison difficult. Some also express the DSCR as a percentage rather than as a ratio.
How does a debt-service cover ratio affect your business loan?
Regardless of how a lender arrives at the DSCR, the concept itself is immensely important to the process of applying for a business loan. The value of your ratio plays a huge role in helping lenders to determine if your business deserves the requested loan amount.
Although other factors such as credit history and loan collateral will be considered as part of your loan application, if your ratio is too low, you’ll likely be denied. In general, a ratio of 1.2 is the minimum DSCR 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. Usually, there is no deciding minimum ratio since lenders take into account many factors when looking at your application.
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.
Let’s also consider that you have another already-existing long-term loan that you’re currently servicing. You’ll need to factor this into your total annual debt service. So, if this already-existing loan stands at $40,000 of annual debt service, your total annual debt service would be $70,000.
Next, take your annual net operating income of $80,000 and divide it by your annual debt service of $70,000. This would equal a DSCR of 1.14, a low ratio that would likely prevent your application from being accepted. However, if you’re able to use future financial projections to convince the lender that your second loan would increase income/profits to a level sufficient enough to boost your DSCR, then you may be accepted.
You should always be careful of getting into too much debt, 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 for a loan application.