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Know Your Debt Service Coverage Ratio

This post originally appeared on SmartBiz Loans.

Are you a small business owner ready to seek outside funding? You might think that finding a lender is the initial step. However, there’s an important financial ratio you should understand first. The debt-service coverage ratio (DSCR)helps determine whether or not your business can take on a loan and the size of small business loan you can handle. Additionally, lenders frequently use DSCR as a way to evaluate whether they should lend money to a business. Having a good debt service coverage ratio can be critical to getting low-cost funds for your business.

What is the Debt-Service Coverage Ratio?

DSCR measures a business’s ability to cover its debt payments. Debt payments can include loan or credit card payments, leases or other costs associated with running your business. To put it simply, DSCR shows how much cash a business has to cover loan or other debt payments.

Calculating Debt-Service Coverage Ratio

You can calculate the DSCR of your business by dividing your net operating income by total debt service. DSCR is frequently a number between 0 and 2.

Debt Service Coverage Ratio = Net Operating Income ÷ Total Debt Service

If debt service coverage ratio is 1.5, this means a business’s cash flow can cover 150% of its yearly loan payments. Similarly, if a business’s debt service coverage ratio is 0.8, this means that the business can only cover 80% of its yearly loan payments.

What DSCR Do I Need to Qualify for a Business Loan?

All lenders have their own criteria for evaluating your DSCR but generally speaking, you have a good chance of qualifying if your DSCR is greater than 1.25. The higher your DSCR is above 1.25, the greater the chance that you will be approved and receive the best terms. A business with a DSCR less than 1.0 wouldn’t even be able to cover its loan payments in full. 

How to Improve Your Debt-Coverage Service Ratio

If your DSCR isn’t high enough to qualify for a low-cost business loan, there are a few strategies you can use to raise your number.

One way is to simply increase business revenues. If that’s not a reality at this time, lowering your business expenses can bring the number up. You can also bring down the amount of outstanding debt your business is carrying. Doing all three together has the most impact.

Even if you aren’t seeking a small business loan now, it’s still a good idea to monitor your DSCR in case you apply for a loan down the road.

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