The debt service coverage ratio (DSCR) is a critical term for small business owners and individuals. DSCR indicates the ability of a company, business, or government to repay its debts. However, the ratio is more commonly used in the business world.
Understanding how to calculate the ratio may help business owners to get loans. We have prepared an article with a comprehensive guide to determining the ratio. Our article also focuses on how to increase the ratio to get a loan.
What Is Debt Service Coverage Ratio?
The debt service coverage ratio estimates the company’s ability to utilize its operating revenue to cover all its debt payments. The estimated ability also includes repayment of principal and interest on short-term and long-term debts.
Accountants apply this calculation when the business has the following types of borrowings on its balance sheet
- lines of credit.
DSCR is used not only when analyzing companies. Financial institutions use DSCR to analyze individual borrowers and projects. The minimum debt-service coverage ratio a lender demands will depend on the macroeconomic situation. Typically, lenders are more understanding and forgiving of lower ratios when the economy grows.
The Debt Service Coverage Ratio Formula
The formula requires knowing the company’s net operating income and the total debt servicing for the entity. The company’s net operating income is calculated by subtracting certain operating expenses (COE) from the business’s revenue. The formula doesn’t include taxes and interest payments.
So, the formula is as follows:
DSCR = Total Debt Service / Net Operating Income
In this formula:
- Net Operating Income = Revenue − COE (certain operating expenses)
- Total Debt Service = current debt obligations
The next step is to check all peculiarities of the calculation process.
Keeping proper financial records is time-intensive and small mistakes can be costly. BooksTime makes sure your numbers are 100% accurate so you can focus on growing your business.
The DSCR Calculation Process
It’s clear how to determine the net operating income needed for the equation, but what about total debt service? The total debt service in the equation refers to current debts. It includes interest, principal, sinking funds, lease payments, etc., that must be paid out in the coming year. You will find these obligations on a balance sheet.
Given that interest payments are deductible and included in the equation, it may be more difficult to calculate TDS. People may use a more accurate way to calculate total debt service and make things easier:
(Interest x (1 – Tax Rate)) + Principal = TDS
By using this formula, you can easily calculate DSCR. Other formulas to calculate the ratio may also include capital expenditure. However, the equation above enables businesses to easily calculate their DSCR and determine whether they can apply for a loan.
How to Calculate DSCR in Excel
It’s impossible to use the formula in Excel if you set it so that net operating income is divided by debt service. Instead, create A2 and A3 cells and name them “net operating income” and “debt service,” respectively. Then use the adjacent B2 and B3 cells to add respective figures from the company’s income statement.
Then choose a separate cell to create a formula. Instead of using actual numeric figures from B2 and B3 cells, divide B2 by B3. You get a dynamic formula, and you can later adjust it.
Using actual numeric figures makes the formula static. Typically, this formula is used to compare various companies or projects. It’s easier to make a comparison and run the formula if you can change the figures in respective cells.
Moreover, one of the advantages of using this formula in Exel is that it’s free. Users don’t have to pay for accounting software to compare several companies’ DSCR.
What does DSCR Tell
Now it’s clear how to calculate DSCR, but how does one interpret it? Typically, a DSCR ratio goes by the rule “the higher, the better.” So, a ratio of 1 and above is a good ratio. Here’s what you can tell about a company’s DSCR:
- A DSCR higher than “1” shows that the company has enough cash flow to cover its debt obligations.
- A DSCR lower than “1” shows there is only sufficient operating income to cover 85% of the company’s debt obligations.
Lenders seek companies or projects with a DSCR of 1.15 or higher. Typically, they analyze the economic conditions of the company too to make a decision. The general rule is to never lend money to a company or a person who won’t be able to pay back in the future.
The debt service coverage ratio is a simple formula that offers an insight into the business’s cash flow and whether it has sufficient funds to repay its loan. Lenders often use this formula in real estate or commercial lending since the ratio enables them to calculate the maximum amount a borrower can get. Now let us check in what other cases the ratio is used.
When DSCR Is Used
Typically, DSCR is used in the following areas:
- corporate finance;
- real estate finance.
Moreover, DSCR is also used in the context of government finance and personal finance. In the first case, it indicates the number of export earnings necessary by a country to meet annual interest and principal obligations on its external debts. In the second case, the ratio is used by financial institutions to calculate income property loans.
How to Increase DSCR
Before applying for the loan, consider calculating the company’s ratio. If it’s too low, the company may still get a loan, but it may be smaller than expected. As a result, the company will acquire a new obligation, and the funds won’t help optimize the business.
Instead, consider increasing the company’s DSCR. The best way is to increase the business’s net operating income. Here’s to do it:
- Decrease expenses. Perhaps, negotiations take the most time in the business world. Take a look at the business’s expenses and contracts with vendors. The company may be buying items or materials at too high prices. Consider negotiating the prices and decreasing other expenses where possible.
- Increase efficiencies. Consider improving various areas of the company to increase efficiency. For example, if the company has a customer support system, you may optimize it by investing in a customer support bot. Employees from the support team gain more time to resolve difficult issues, while the bot handles the simplest tasks. The support resolves issues faster, which helps to build customer trust. As a result, you get more profit faster. There are many other areas of business that may be improved.
Other tips include:
- Repay existing debt obligations. The DSCR calculation includes the total debt service. Reducing the total debt service figure increases the ratio. And if the company manages to combine the debt reduction with increasing the net operating income, it’s a guarantee of getting a loan.
- Reduce the amount of a requested loan. If nothing works, the business owner may request a smaller amount of loan, given the ratio.
These simple changes are effective but may require time to implement.
A company called Cool T-shirts makes amazing clothing items with custom prints. The business is registered and located in Boston, but it ships its items internationally. The business is doing great, so the owner wants to expand. Logically, the owner has to apply for a loan to build additional warehouses in other states.
The owner runs a DSCR calculation to see if it’s possible to get a loan:
- Annual net operating income: $850,000.
- Annual total debt payments: $550,000 (including interest).
So, DSCR is:
$850,000/$550,000 = 1.54
As mentioned, the score above “1” is a good. The Cool T-shirts business has a score of 1.54, which puts the company in a great position to receive the loan. The score indicates that Cool T-shirts has 54% more income than debt obligations.
However, as soon as the company applies for the loan, it will be more difficult to get another loan. The score will decrease every time the business takes on a new loan. That’s why business owners have to ensure they spend on optimizations that help grow the company and thus, increase the profit.
Author: Charles Lutwidge