Holly founded ExitPromise.com as well as StartupPromise.com and so far has answered more than 3,000 questions asked by business owners about starting, growing and selling a business.
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The debt service coverage ratio (also referred to as the DSCR) is a measurement used by lenders to determine if a business is able to meet its debt servicing obligations through its operating income during a given period of time.
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.
Holly Magister,
How could be DSCR Negative???
Yes, it is possible if the income is negative to start with and the add backs to the computation are not sufficient to cover the (business loss) negative amount.
It is also possible for a business to have a loss (negative amount) and after adding back interest, depreciation, etc. to have sufficient debt service (cash flow) to ‘cover’ its annual debt service requirements.
Holly,
when figuring your Annual Expenses (exec. Dep. & Int.) what other expenses get factored in the calculation? Real Est. Taxes, Ins. Maintenance Exp.?
Hi Sue,
I am sorry I am having difficulty understanding your question.
Generally, Annual Expenses would include all expenses related to running your business for the year.
If that doesn’t help, let me know and I will try again!
Hi this is a very amateur question but does the net operating income include mortgage payments on the property?
Hi Leslie,
Net Operating Income is calculated after the expense portion of the mortgage payments are made. In other words, if a mortgage payment includes principle, interest expense, and real estate taxes, the Net Operating Income amount would be net of the interest expense and real estate tax expense.
Not an amateur question at all Leslie!
All the best…
If an owner of a S Corporation received distributions from the company but then loaned some of those withdrawals back to the company, would you add the funds loaned back to the company to the cash available to service the debt in the calculation?
Or if they used part of their distribution to pay off their shareholder receivable, would you add this back to cash available to service the debt in the calculation?
Hi Kim,
The DSCR is a measurement of cash flow produced by generating income from the business. What you are asking about is a form of cash flow and is reported as such in the Statement of Cash Flows, however it’s source is a form of capital (loans or equity).
So the answer to both questions is ‘no’.
Typically a bank or other lender wants to use the Debt Service Coverage Ratio to measure the company’s ability to produce enough cash from its operations to pay its debt service (interest and principle). So that’s why capital sources of cash flow does not have any impact (positively or negatively) on the DSCR.
I hope that clears up the matter for you–great question!
All the best to you Kim…
Please let me know why Interest is added to Net profit along with Depreciation in the numerator side of DSCR RATIO. Also clarify whether interest in this regard is for the existing loan or proposed loan or both.
Hi Ramdas,
The Debt Service Coverage Ratio is intended to measure the ability of a business to pay (or cover) its debt service requirements for a given period of time. For this reason, adding depreciation is necessary because depreciation is a non-cash deduction (which decreases net income). By adding depreciation back to net income, a true net cash flow measurement is possible.
Debt service is interest and principal payments for a loan (or line of credit) during a given period of time. And the reason interest is added back to net income in the DSCR formula is because it is part of the debt service measurement. If it were not added back, it would not properly measure net CASH FLOW available to pay debt service.
If a loan (or other debt instrument) is contemplated, the existing net cash flow would be measured against the proposed loan’s debt service requirements (interest and principal).
And once a loan (or other debt instrument) is in place, the DSCR is measured on an ongoing basis.
All the best…
Have you seen a debt service coverage ratio that subtracts distributions paid to shareholders? What is the purpose of this calculation?
Hi Tara,
Yes, it is not unusual for a bank to include a deduction from cash flow for shareholder distributions.
A debt service calculation (and loan covenant) is meant to measure how much cash is available from a business operation (cash flow) to meet its obligation to pay the lender’s loan (principle and interest) payments. In really simple words, it measures the borrower’s ability to pay the lender back.
A lender may force a borrower to deduct the shareholder’s distributions from its cash flow when calculating the Debt Service Coverage Ratio to discourage excessive distributions. This is often the case when large shareholder distributions have been made in the past or when the anticipated DSCR is ‘tight’ or close to the lender’s lowest acceptable ratio.
Great question, and I hope this is helpful!
All the best…
How do you calculate debt service ratio for 3 months? Is only the 3 months of operating income considered? Do you use the principal and interest incurred in those same three months?
Thank you.
Hi Karrie,
I don’t believe I have ever needed to calculate the DSCR on a three month basis.
Having said that, you could simply multiply the three month net income figure by four to get an annualized Net Income and then divide it by the Debt Service (which includes Principal and Interest payments on all debt) to determine the DSCR.
I hope this helps Karrie!
Debt service is easy to calculate but why do some banks allow reimbursable expenses to be added back to net income (which were previously subtracted from it)? Example: NOI = Revenue – (Reimbursable Exp + Non-reimbursable Exp) + Reimbursable Exp
Hi Ted,
I would agree with you… it’s a bit confusing.
First, please note the post was written in the context of bank lending for a business owner and your question is related to bank lending for a rental property. They are not the same!
Having said that, I think I may be able to shed some light on this for you.
What the bank is doing is essentially saying your NOI (Net Operating Income) is equal to your Revenue less your Non-Reimbursable Expenses. In rental real estate, a non-reimbursable expense would be an expense the landlord must pay out of cash flow. Whereas, a reimbursable expenses is an expense the tenant (ultimately) pays.
The bank’s formula provides a measurement of true (and net) cash flow from a rental property after the tenant has reimbursed the landlord for certain expenses and is used for the purpose of calculating the property’s debt service coverage ratio.
I hope this helps you Ted!
All the best…
Simple question I think, but I can’t seem to wrap my head around it. What if the property doesn’t meet its DSCR requirement, say 1.25x. How would I calculate what the NOI needs to be to meet the 1.25x?
Hi Jon,
To determine how much the NOI (Net Operating Income) needs to be given a 1.25 DSCR (Debt Service Coverage Ratio) requirement, you would multiply what your bank defines as debt service by 1.25.
For example, if your debt service is defined as the total payments payable to the bank for one year as $72,000., then you would multiply $72,000 by 1.25, which equals $90,000. You would need to have $90,000 NOI in order to meet the 1.25 DSCR requirement.
I hope this is helpful Jon!
All the best…
Why is depreciation added in dscr ratio
Hi Sarithaamin,
The purpose of the Debt Service Coverage Ratio (DSCR) is to determine if a business is able to generate enough cash from its operations to meet its debt service requirements (i.e. pay the debt’s principle and interest) in a given period of time.
Accordingly, depreciation is a non-cash expense so it is added back to operating net income.
All the best…