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.
What is the difference between gross DSCR and net DSCR? What its significance?
Hi Prasad,
This post covers DSCR in the context of business lending and borrowing.
I believe you’re interested in learning about personal lending and borrowing because the concept of Gross DSCR is related to mortgage and other types of consumer lending. Gross DSCR is a measurement of an individual’s or couple’s overall (gross) monthly debt payments or obligations as a percentage of his/her or their personal gross income.
I have no idea what Net DSCR is! That said, Net Operating Income is one of the measurements in the Debt Service Coverage Ratio in the context of business lending and borrowing. Maybe this is what the Net DSCR measurement is?
Hope this helps a bit…
Hi Holly,
Imagine a situation where a company pays some of its short term debt and borrows some more during the year. Should we get the net amount of such debt. For example A Company Pays $X as capital payment and borrows $Y amount during the year. Should the capital payment be Y-X?
Hi Ushira,
I am having trouble understanding your question.
In the context of the DSCR computation, the capital is the principle payment made to the lender. So, the net balance of the short-term borrowings owed at a particular point in time have nothing to do with the Debt Service Coverage Ratio computation.
Does this answer your question? If not, please elaborate and I will give it another try!
Hi, let’s say the debt covenant requires minimum 1.15x DSCR. I understand that it measures the operating cash flow (lets say annually) of the business but let’s say if i have the FCFE projection that goes with EBITDA-taxes-CAPEX=CAFDS and using that CFADS to divide by my debt service i get something below <1.0x. However the company actually generates quite a bit of cash in the previous year that flows into my cash flow statement as opening cash balance. Can i count those excess cash in the previous year in this year's DSCR calculation. Thanks.
Hi Erica,
FCFE is an acronym for Free Cash Flow to Equity and it is a measurement used for shareholders (owners), whereas Debt Service Coverage Ratio (DSCR) is a measure used for lenders. Although both measure cash, relative to other financial figures, they are not the same animal.
CAFDS is an acronym for Cash Available For Debt Service which measures cash (and other cash equivalents) on the company’s balance sheet relative to debt service, whereas DSCR uses Cash in the formula which has been generated in the current period (typically one year). CAFDS measures cash retained on the balance sheet at a specific time and DSCR measures cash earned and reported on the income statement during a period of time. Again, not the same animal.
With this said, lenders who require a borrower to meet a DSCR in its loan covenants typically define the measurement very clearly. If you want to your lender to consider the cash sitting on the company’s balance sheet as a measurement of its ability to meet its loan payments, then you should consider asking for it. As with most loan covenants, it’s negotiable.
All the best Erica…
Hi
What are the factors that you would consider while funding a restaurant
Hi Sunny,
If you are considering funding a business (restaurant or any other) with capital as a loan, the single most important factor to consider is cash flow.
Cash Flow tells a lender whether the business is likely to make the loan payments as agreed.
Computing the business’ DSCR is one way to determine if cash flow will be sufficient during the loan term.
Other factors a lender should consider is whether the business owner has good credit history (business and personal) and whether there are assets which can serve as collateral if the business owner doesn’t fulfill his/her promise to pay back the loan in full.
Banks look at these factors when they consider lending any business money and so should a private investor!
All the best…
A medical group is just being formed. It will need $2 million of total assets to generate $3 million in revenues. They expect to have a profit margin of 5%. They are considering two financing alternatives. It can use all equity financing or finance up to 50% of its total asset with bank loan. The debt alternative has no impact on profit margin, what is the difference between the expected ROE if the medical group finances 50% debt verses the expected ROE if it finances entirely with equity capital?
Hi Victor,
Without knowing the cost of the debt financing, I am not able to tell you what the ROE difference is in terms of a percentage between the two capital structures you’ve proposed.
That said, when debt is part of a capital structure, generally speaking the ROE increases or is greater than it would be if debt is not used as long as the cost of debt (the interest rate) is not too high. This is why businesses leverage or borrow money to capitalize their invested assets and/or operations.
If your revenue is $150 per visit and variable cost $70 per visit and fixed cost of $45,000,000 and your debt service is $750,000. How many visits do you need to reach a debt service coverage ratio of 1.25?
Hi Victor,
First, you’d solve for the amount of cash flow your business would need to produce to meet the minimum DSCR of 1.25 by multiplying $750,000 by 1.25.
That amount is $937,500.
Then you’d add $45,000,000 to $937,500 to compute the amount of gross profit your business would need to generate.
Gross Profit would need to be at least $45,937,500.
If each visit generated $80. Gross Profit ($150 less variable cost of $70), then you’d divide $45,937,500 by $80 to conclude your business would need at least 574,219 visits to meet its DSCR of 1.25.
Let’s do a quick proof:
$574,219 Visits X $80 Gross Profit = $45,937,520.{Gross Profit}
$45,937,520 less fixed cost of $45,000,000 = $937,520 {Net Profit and Cash Flow for example purposes}
$937,520 Cash Flow divided by $750,000 Debt Service = 1.25 Debt Service Coverage Ratio
Great Thank you that was spot on.
It was my pleasure Victor!
That’s a lot of customer visits 🙂
All the best…
shall we include interest on overdraft for calculating DSCR
Hi DPR,
The only interest that should be included in the DSCR computation is the interest related to servicing the debt.
In the case of an advanced refunding, do I include the Escrow paid portion of debt service during the period of ownership by the entity or just the entity’s paid portion of debt service?
Hi Sally,
A refund of the escrow balance would not be included in the computation of the DSCR. Only the principal and interest to ‘service the debt’ is used in the computation.
Hi Holly Magister, I want to Calculate Annual Payment(Debit Service).
For example :
NOI = 895000
Commercial loan : 100,000
Interest : 6.5%
Term : 30 Year
Annual Debit Service = ?
DSCR = NOI/Annual Debit Service
How to find Annual Debit Service
Thanks
Hi Arfan,
First, you need to calculate the loan payment and then multiply the monthly payment by twelve to compute the Annual Debt Service.
Here’s a loan amortization calculator which will calculate your monthly loan payment to be $632.07 which when multiplied by twelve is $7,584.84.
Then to calculate your Debt Service Coverage Ratio, based on your Net Operating Income, you divide the NOI by the Annual Debt Service. In your case, $895,000 divided by $7,584.84 is 118, which is a very healthy DSCR!
Is DSCR considered interest paid in Cash Credit Limit or Bank overdraft
Good morning Nishant,
Interest paid on a loan or other credit facility is one component of the Debt Service Coverage Ratio computation. The cash credit limit (typically associated with a credit card) is not. Nor is bank overdraft charges.
Can CF (Cash Flow) be positive, but DSCR <1? If can, When? Tnx.
Good morning,
I am not certain I understand how you are computing ‘cash flow’. With that information, I should be able to answer your question.