In this article, you’ll learn:
- What debt service coverage ratio (DSCR) is
- How to calculate DSCR
- What a good DSCR is
- How to improve your DSCR
- How to overcome a relatively low DSCR
- What global DSCR is
According to the Biz2Credit Small Business Lending Index, loan approval percentages at big banks, small banks, institutional lenders, alternative lenders, and credit unions are still roughly half of what they were in January 2020. In many cases, lenders deny borrowers’ small business loan applications because they don’t meet quantitative metrics – one of these metrics is the debt service coverage ratio.
What is Debt Service Coverage Ratio?
Debt service coverage ratio (DSCR) is a number that shows whether a company has enough cash flow to pay its current debt obligations.
How to Calculate DSCR
To calculate your DSCR, start by figuring out your EBITDA, which is your earnings before interest, tax, depreciation, and amortization. Next, add up your current debt obligations. Lastly, divide your EBITDA by your current debt obligations.
Say you have EBITDA of $300,000 and current debt obligations are a total of $250,000. In this case, your DSCR calculation would be 300,000/250,000 = 1.2.
Here’s a debt service coverage ratio calculator to save you some time.
What is a Good DSCR?
A debt service coverage ratio of one or higher indicates that a company has enough income to satisfy its current debt obligations. A DSCR of below one, on the other hand, shows that your company can’t cover all of its debt payments.
So, does that all mean that lenders are happy with a DSCR of one or higher?
There are no guarantees in the business world, so lenders want to protect themselves against fluctuating EBITDA. For example, a lender might not want to approve a small business loan that would leave a borrower with $150,000 in EBITDA and $150,000 in current debt obligations, as any decrease in EBITDA could prevent them from making the monthly payments.
The minimum DSCR depends on the lender, industry, and company outlook, but a DSCR of 1.2 is a common requirement for borrowers seeking small business loans.
How to Improve DSCR
To improve your DSCR, you need to either increase your EBITDA or decrease your debt obligations.
Let’s look at how you can accomplish each of those objectives.
Increase Your EBITDA
Your EBITDA is a good indicator of your business performance, as it removes some extraneous factors that impact a company’s bottom line number. As such, the metric is commonly used by lenders to determine a company’s ability to satisfy debt obligations.
As a small business owner, you’re always looking for ways to increase your earnings. Here are a few possibilities to consider:
- Focus on retaining your existing customers. This might seem obvious, but it’s hard to overstate how important it is to retain customers. According to Harvard Business Review, acquiring a new customer is anywhere from five to 25 times more expensive than retaining an existing one. If you spend on solid retention strategies, you’re likely to see a strong ROI.
- Deploy cost-effective marketing strategies. To increase earnings, you have to grow revenue relative to operating expenses. Through cost-effective marketing strategies, you can get the word out about your company without breaking the bank. A Super Bowl ad costs several million dollars, but you can build a top-notch website and excellent social media presence for a low five-figure sum.
- Hire additional employees. It’s not cheap to hire quality employees, but if you have a company in a growing market, you might be able to increase your annual revenue by much more than the employee’s salary on an annual basis.
- Consider raising your prices. The inflation rate has been high for several months, and one of the ways to prepare your small business for inflation is by raising prices. How do you know how much to raise prices? The exact amount depends on the overall inflation rate, demand for your products/services, and your customers’ sensitivity to higher prices.
- Leverage software to increase efficiency. There are still a lot of tasks that can only be done by humans, but there are plenty of things that software can do faster, better, and cheaper. In some cases, you want a human to leverage software to complete tasks; for example, a human bookkeeper and bookkeeping software are both necessary to efficiently and effectively keep books for your small business.
Decrease Your Debt Obligations
There are more paths to higher earnings than to lower debt obligations, but it’s far from impossible to reduce your debt. Here are a few options:
- Try to refinance your existing loans. You might be able to refinance some of your existing loans. By negotiating a lower interest rate, you reduce your monthly interest payments – this lowers your debt obligations. You are more likely to successfully refinance a loan if you have good business credit and you haven’t missed a loan payment, but even if you don’t have a solid history, it doesn’t hurt to give it a shot.
- Pay down your existing debts. If you have a DSCR of around 1.05 to 1.15, you should consider using some of your excess cash flow to make extra debt payments. Say you have $110,000 in EBITDA and $100,000 in debt obligations, which works out to a DSCR of 1.1. By using some or all of that excess $10,000 a year to make prepayments, you might be able to push your DSCR towards 1.2, increasing your chances of qualifying for a small business loan.
- Don’t take on new debt until your DSCR increases to a healthy level. For some small business owners, the best way to increase their DSCR is by taking the long view. Say you have $200,000 in EBITA and $185,000 in current debt obligations, which works out to a DSCR of around 1.08. Of those $185,000 in current debt obligations, $50,000 is going to be eliminated over the next year, bringing your debt obligations down to $135,000 (if you don’t take on more debt) and your DSCR up to around 1.48.
Try to Increase Your EBITDA and Decrease Your Debt Obligations
Since there are no guarantees in the business world, you should try to increase your EBITDA and decrease your debt obligations for best results. By doing this, you can increase your DSCR even if some of your strategies aren’t successful. And if you are successful in both objectives? You’re going to have an outstanding DSCR, making it much easier for you to qualify for small business financing with attractive terms.
How to Overcome a Relatively Low DSCR
The strategies to improve your DSCR take time to show results. So, how do you get a loan if you have a relatively low DSCR… and no time to increase earnings or reduce debt?
Let’s look at a few options:
Offer Lenders Collateral
Does your business have valuable equipment or real estate? If so, you may be able to offer them to lenders as collateral. By doing this, you can alleviate a lender’s concerns about what would happen if you fail to make your monthly debt payments.
Provide a Personal Guarantee
This option should be carefully considered, as it means putting your personal assets at risk. But if you are only able to get a loan with really unfavorable terms or you aren’t able to get any type of loan, you should at least explore this possibility. You should only provide a personal guarantee if you are extremely confident in your company’s ability to make monthly repayments. It’s best to talk to a CPA before moving forward with this option.
Leverage a High Credit Score
Do you have a high credit score? If so, a lender may be willing to overlook a relatively low DSCR – assuming it is one or higher. From the lender’s point of view, a solid credit history indicates that the borrower knows how much debt can be handled by the business.
What is Global DSCR?
Global debt service coverage ratio (DSCR) is based on business income and business debt, as well as personal income and personal debt. So, global DSCR is a broader metric than the standard DSCR formula.
For small business owners who have a strong personal balance sheet, it may make sense to leverage their global DSCR to qualify for a small business loan. On the other hand, a small business owner with a weak personal balance sheet may struggle to get approved for a business loan if global DSCR is taken into the equation.
The Bottom Line
As an entrepreneur, your DSCR is one of the most important metrics for your small business. By understanding how to calculate your DSCR and how to improve your DSCR, you are better positioned to get a new loan with favorable terms.