Hi, I'm Priyanka Prakash, senior staff writer at Fundera.
When applying for a business loan, one phrase you'll hear a lot is debt service coverage
ratio or DSCR.
Lenders basically use DSCR to figure out if you are financially able to pay back the loan
that you're applying for, as well as any business loans that you might already have.
Today, I'll walk you through the DSCR formula, as well as a few examples, so you know exactly
how to meet this requirement when you apply for a business loan.
DSCR basically tells you whether your business's net operating income is enough to cover your
business debt payments.
Ideally, your business’s net operating income, or NOI, should be about 1.1 to 1.2 times higher
than your business's debt payments, as this graph indicates.
We'll talk more about lenders specifics in a second, but first I'm going to show you
the DSCR formula.
The DSCR formula actually isn't too complicated.
You simply take your business's annual net operating income and divide it by your business's
annual debt payments.
Now, most lenders look at DSCR on an annual basis, so you should as well, but if you're
applying for a short term loan, it might be better to calculate DSCR on a monthly basis
or quarterly basis.
Just make sure you're comparing apples to apples.
For example, for annual DSCR, you divide annual NOI by annual debt payments.
For a quarterly DSCR, you would divide quarterly NOI by quarterly debt payments, and for a
monthly DSCR, you would divide monthly NOI by monthly debt payments.
Okay, now that we have the formula, let's look at a basic example.
Let's say you're applying for a business loan for your restaurant and your annual NOI is
$100,000.
Let's say that you also have $75,000 in total business loans.
That might be $25,000 in existing debt and $50,000 of new debt that you're applying for.
However the breakdown, I've emphasized “all” here to remind you that you should take existing
debt and new loans into account.
And for simplicity, let's say that this $75,000 includes the loan principal and interest.
To calculate DSCR, you would simply take your $100,000 of annual NOI and divide it by your
$75,000 of annual debt payments to get a DSCR of 1.33.
We'll talk about whether this is a good DSCR in just a minute, but first I want to cover
a couple of other ways of looking at DSCR.
Suppose you know what the lender’s minimum required DSCR is.
For example, maybe you found this information on the lender’s website or asked them about
their specific requirements, and they told you that their minimum DSCR was 1.15.
Assuming you have the same $100,000 of business NOI, you can flip the formula, dividing $100,000
by the 1.15 DSCR, which gives you $86,957 in annual debt payments.
This is your maximum annual debt service, which means your yearly loan payment should
be no higher than $86,957 when including for both principal and interest.
Finally, you can take this a step further by calculating the maximum monthly payment
on your loan.
Take the maximum annual debt service from the previous example, and divide by 12 months
in a year to get a maximum monthly loan payment of $7,246.
If a lender charges payments on a weekly or bimonthly basis, you would simply divide the
debt service by the number of those periods in one year to get the maximum payment.
So now that you've calculated DSCR, you're probably wondering, is your DSCR good?
And will you be able to qualify for the loan that you're applying for?
Let's look at that next.
What makes a good DSCR?
Well, as I alluded to earlier, most lenders prefer a DSCR of 1.1 or higher.
If you have a DSCR greater than one, you're in a good spot because it means that you can
comfortably cover your debt payments with your current net operating income.
A DSCR of one means that you're breaking even, so you have just enough cash to cover your
debt payments, but not much wiggle room.
If you make lower than expected revenues for the year, or if you lose a big client, you
could wind up in the negative and you could be unable to pay back your loan.
Lastly, if your DSCR is below one, that means you cannot afford the loan payments.
Given your current net operating income.
Global DSCR is a variation on regular DSCR that many small business owners aren't familiar
with.
Global DSCR is different because it includes your personal income and personal debt in
addition to business income and business debt.
Let's take a look at an example.
Let's say that you run a restaurant with an annual net operating income of $100,000, but
you also have a personal day job that brings in $40,000 per year.
In terms of debt, you have your $75,000 of business debt, but you also own a home and
have a balance on your mortgage of $55,000.
When you add up the income in the numerator and the debt in the denominator and divide,
you get a DSCR of 1.8.
If you remember our previous example when we looked just at business NOI and business
debt, we had a DSCR of 1.33.
As this example shows, global DSCR will typically be lower than regular DSCR, especially if
you have a significant amount of personal debt.
But, lenders also have lower requirements for global DSCR because they understand that
you might be coming to the table with some personal loans.
Now, we mentioned before that you should check in with your lender about their required DSCR
minimum.
This is a good idea because if you don't meet the requirements, you should focus on improving
your DSCR instead of starting in on a long application process.
DSCR relies on two factors--income and debt--so you can make improvements from either of those
two angles.
On the one hand, you can try to increase your revenue.
For example, you might be able to cut costs or bring on a new client or find some other
way to generate more income.
On the other hand, you can try to minimize debt levels.
That might mean trying alternatives to debt when raising capital or refinancing existing
debt with a lower interest loan.
And that's our explanation of debt service coverage ratio or DSCR.
If you have more questions related to small business lending, we have a wealth of information
at fundera.com/blog.
You can also subscribe to our YouTube channel for more videos that will help you reach your
business goals.
Thanks for watching, everyone.