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In most cases, a lender wants the operating income to exceed the debt servicing costs by some measure. This ratio defines the extent to which a business’s operating income (or other defined measure of cash flow) exceeds the cost to service its bank loans.
Debt servicing is the summation of the loan principal and interest (or cost of capital), and sometimes lease payments, paid to a lender and others on an annual basis.
The debt service coverage ratio is determined by comparing the business’s operating income (or other defined measure of cash flow) to the debt service costs during a given period of time.
It’s common to find a debt service coverage ratio defined or stated in a bank loan document. In many cases a minimum ratio is defined in a loan agreement as a positive loan covenant. When this is the case, the debt service coverage ratio is defined by the bank and the business owner positively affirms or promises it will maintain a minimum debt service ratio of 1.XX to 1.0 for the duration of the loan.
The expected excess operating income coverage varies, however it is usually in the 20 to 25% range. As such, the expected minimum debt service coverage ratio would be defined as 1.20 to 1.0 or alternatively 1.25 to 1.0.
How to Calculate the Debt Service Coverage Ratio
In order to calculate the debt service coverage ratio, you need to know:
- The net operating income (NOI) the business earned during the previous 12 months (or whatever measure of cash flow the lender defined in the bank loan covenant)
- The amount of principal, interest, and sometimes lease payments (Debt Service) paid to the lender and others for the previous 12 months
Divide the NOI by the Debt Service and you will have a value which should be taken to the second decimal point.
For example, if a business NOI was $95,000 and its Debt Service for the same period is 62,500, then the Debt Service Coverage Ratio would be 1.52 to 1.00 ($95,000 divided by 62,500). If the lender requires a debt service coverage ratio of 1.25 to 1.0, this business would exceed the requirement and be in compliance with its bank loan covenant. If on the other hand, the debt service coverage ratio was less than 1.0, then the borrowing business would be producing ‘negative cash flow’ which is not desirable.
If you would like to calculate your global debt service coverage ratio (DSCR), this handy tool may be helpful.
Why is a Debt Service Coverage Ratio Important?
Business lenders don’t like to lend money to businesses that are unable to generate enough cash from their normal day-to-day operations to pay back both principal and interest. If you think about this for a minute, it makes good sense. A business not generating enough operating income (or cash flow) to pay the loan payments (principal and interest) for an extended period of time is a business that’s not generating enough profit to warrant a business loan.
Typically, the debt service coverage ratio is required to be measured annually and reported to the lender within a few weeks or months of the business’s year end. Keeping track of this ratio on a monthly (or at least quarterly) basis is wise so you don’t reach the end of the year and find you’ve broken this important bank loan covenant.
How Could a Debt Service Coverage Ratio Loan Covenant Be Negotiated by a Business Owner?
Most entrepreneurs don’t pay any attention to the bank loan covenants often times because they simply don’t understand them.
Unfortunately, the debt service coverage ratio business bank loan covenant is one of the easiest covenants to break without even knowing it. So it’s worthwhile to understand this covenant and the aspects which may be negotiable before signing a bank loan.
Here are a few tips:
- Be certain to fully understand what is defined as ‘coverage’ in the debt service coverage ratio computation.
- Is it net operating income? Are you able to add back interest expense, depreciation or amortization to NOI to get to a figure that more closely represents ‘cash flow’?
- What about corporate income taxes paid by the business? Can those be added back to NOI when calculating the coverage figure?
- Could EBITDA be used? What about Adjusted EBITDA?
- All variations of the definition of NOI or cash flow coverage should be carefully considered and negotiated with lenders.
2. Many business owners have multiple businesses and operate several business entities. If you are among those serial entrepreneurs, you may find yourself in a circumstance where one of your businesses is not producing sufficient NOI (or cash flow) to meet its debt service coverage ratio while another business is producing excess NOI.
- Combining the NOI and debt service amounts from all entities owned may offer you a way to meet your debt service coverage ratio covenants. This is known as a global debt service coverage ratio and should be carefully considered and negotiated with lenders.