CAGR, EPS, NAV, ROCE — business finance is filled with confusing acronyms. Fortunately, you don’t need to remember most of them as long as you have a handle on the most important of all: DSCR.
If you rely on lending of any type to procure funding for your business, your debt-service coverage ratio (DSCR) should be on your mind at all times. A measure of your cash flow available to pay existing debts, the DSCR is a vital calculation for all business leaders. Yet, because DSCR isn’t a sexy term or flashy concept, it isn’t often discussed on business blogs — which means, if you are new to business leadership, you might not know much about it. This guide to everything DSCR should help.
What Is Debt Service?
Though the name makes it sound like some complex process of acquiring debt, in truth, debt service is simply the cash required to cover repayment of a debt’s principal and the interest for a certain period. Individuals seeking student loans or mortgages must calculate their debt service to properly budget, and lenders must meet debt service requirements for loans issued to the public. Similarly, businesses should have a firm grasp of their debt service to avoid drowning in debt and to be capable of raising additional capital to grow larger and stronger. As you can see, debt service is a term you should become familiar with, both for your business funding efforts and your personal financial health.
What Is the Coverage Ratio?
The second half of DSCR, the coverage ratio compares an entity’s net income with its existing debt services. The resulting figure is one used by lenders to determine whether potential borrowers have enough cash available to cover additional loans.
A DSCR of less than one indicates negative cash flow. For example, if your business has a DSCR of .95, it means you only have enough income to pay for 95 percent of your debts; the remaining 5 percent must come from savings accounts. A DSCR too close to one, perhaps around 1.1, indicates financial vulnerability, and a DSCR well above one — ideally above 1.25 — is a good indication of financial health. Your business has a DSCR unique to its financial situation, and it is high time you know that figure.
How Do I Calculate It?
The formula for generating your DSCR is so simple, you hardly need a debt service calculator. However, you do need to understand a few business finance terms first:
- Net operating income: revenue minus necessary operating expenses
- Non-cash charges: expenses not accompanied by cash outflow, such as depreciation of assets
- EBIDTA: earnings before interest, taxes, depreciation, and amortization
- Maturities of long-term debt: financial liabilities that are coming due within 12 months
With these figures in-hand, you can calculate your DSCR two ways — which is useful for ensuring you have the correct number. Here are the formulas:
(Annual net operating income + depreciation and other non-cash charges) ÷ (interest + current maturities of long-term debt)
(EBIDTA) ÷ (interest + current maturities of long-term debt)
During your calculation, you should take your resulting figure to the second decimal point to mirror the figures used by lenders. For an even more accurate figure, you can integrate income taxes into the equation, which requires dividing maturities by (1 – tax rate) before tabulating the rest.
Why Does It Matter?
The debt-service coverage ratio matters significantly to lenders, who risk much by proffering loans to financially unstable entities. By calculating DSCRs, lenders have a better understanding of their potential borrowers’ financial situations and can avoid the riskiest investments. That isn’t to say no lenders will work with businesses whose DSCRs are near or below one; rather, they are fewer and farther between, and often lenders who do work with low DSCRs offer higher interest rates or other costly conditions. The minimum DSCR most lenders are willing to consider fluctuates with macroeconomic conditions: In a growing economy, lenders are often forgiving of lower ratios — just as in the booming pre-recession era, banks hardly hesitated to offer loans to borrowers with low or no credit.
However, knowing your DSCR is useful for more than just reporting to potential lending firms. In fact, regularly calculating your DSCR is a quick and easy way to judge the health of your business’s finances. Debt-service coverage ratio might sound complex and unwieldy, but you will come to rely on this simple figure in your coming years as a successful small business leader.