Table of Contents |
There are several ways to monitor your business’s financial health. One that’s incredibly powerful, and signals to both you and potential lenders that you’ll be able to pay off debt (as well as maintain some financial flexibility), is the debt-service coverage ratio (DSCR). What is DSCR?
“This essential metric measures your company’s ability to cover its debt obligations with its available cash flow. By comparing your net operating income to your total debt service (including principal and interest), DSCR shows whether your income is enough to pay off your debts,” said Credibly Founder Ryan Rosett.
Monitoring metrics like your DSCR can also help you effectively navigate a changing monetary landscape. Debt for small businesses decreased 6% in 2021, and that’s in no small part thanks to effective management of business financial wellbeing.
In this blog post, we’ll explain what DSCR is, discuss how you can calculate yours, why you should keep an eye on your ratio, pros and cons of DSCR, and how you can improve your ratio.
What is DSCR? What does DSCR stand for?
The debt-service coverage ratio (DSCR) is a vital financial metric used to assess a company’s ability to meet its debt obligations. It measures your available cash flow against your current debt, providing a clear picture of whether the company has enough income to cover its debts.
How is DSCR calculated?
The DSCR ratio is calculated by dividing net operating income by debt service, which includes both principal and interest payments. This ratio is crucial for gauging a business’s capacity to repay existing loans and take on future financing.
The formula goes:
Net operating income / Debt service
You should keep in mind, however, that DSCR can mean something different depending on the industry- for example, in real estate.
| What about DSCR in real estate?
For real estate, DSCR measures a property’s ability to generate enough income to cover its annual debt obligations. It’s a key factor that lenders use to assess the maximum loan amount a real estate investor can secure when applying for a new loan or refinancing an existing mortgage. |
Why should entrepreneurs keep an eye on their DSCR?
A higher DSCR indicates that your business generates sufficient income to cover its debt obligations, marking financial health and stability. Conversely, a lower DSCR may signal potential difficulties in meeting debt payments, raising concerns for investors and lenders.
To improve your DSCR, you can either increase your income or reduce your debt. This ratio is especially important for companies that are highly leveraged with debt, as it serves as a widely recognized indicator of financial health.
Lenders, stakeholders, and partners closely monitor DSCR metrics, often including DSCR terms and minimum requirements in loan agreements. These terms ensure that the borrowing company maintains a certain level of financial stability, protecting the interests of the lenders.
By understanding and managing their DSCR, business owners can better navigate their finances and maintain a healthy balance between income and debt obligations.
| Learn more about effective financial management: |
What is a good debt service coverage ratio?
An ideal DSCR is 1.25 or higher, meaning the business generates at least 1.25 times the income needed to cover all debt payments. This ratio provides a financial buffer, showing strong financial health and less risk for lenders.
For instance, a DSCR of 2 is generally considered very strong, and marks excellent financial stability.
On the other hand, a DSCR less than 1 is a red flag, suggesting that the business does not generate enough income to cover its debt obligations. Banks and lenders typically look for a DSCR above 1.00 to make sure that the business can pay its debt and still have some income left over.
A DSCR of at least 1.25 is often preferred because it shows the business has the working capital needed to operate with some flexibility.
When the economy is stronger, higher profits can boost your DSCR and make it easier to secure loans and invest in growth opportunities like new equipment or expanding operations. During economic downturns, however, your profits might decrease and your DSCR may dip and make lenders more cautious.
Regardless of industry, maintaining a healthy DSCR is essential for gaining lender confidence and maintaining financial stability. You should aim for a DSCR of 1.25 or higher to demonstrate your ability to manage debt effectively and to position your business for future growth and investment opportunities.
You could qualify for up to $600,000Speak with our financial experts about ways we can help your DSCR. |
How can you improve your DSCR?
To improve your DSCR, you need to either increase your income or reduce your debt. Here are several strategies to consider:
- Negotiate better contract terms with vendors
Try negotiating better prices and terms for raw materials or even consider changing vendors to secure more favorable deals. You might look into working with an alternative lender who may offer more flexibility.
- Pay off business loans
Pay off some of your existing debt to lower the overall amount owed. Reducing your debt load directly improves your DSCR by decreasing the debt service requirements.
- Look beyond making more money
Instead of only trying to increase sales, look for ways to cut expenses. Evaluate your prices, or trim utility and labor costs where possible.
What are the pros and cons of measuring DSCR?
| Pros | Cons |
| Find trends and improve planning. DSCR helps analyze the financial performance trend of a company over time.
By calculating DSCR monthly, a company can identify trends, such as a declining DSCR signaling a potential decline in financial health. This analysis can be valuable for budgeting and strategic planning. Benchmark against competitors. Business owners can compare its DSCR with competitors to assess relative financial health and efficiency in using loans to drive growth. Assess financial health. DSCR provides a more accurate and exhaustive view of a company’s financial health since it is considered on a rolling annual basis. |
No standard formula. There is no single standard formula for DSCR. Different lenders may use net operating income, EBIT, or EBITDA in their calculations.
This may lead to inconsistencies, as these measures do not account for all expenses, such as taxes. Does not fully account for all expenses. As the DSCR calculation does not always factor in additional costs to the business, like tax or interest costs, this number might only show part of the story. |
