# Understanding the Debt-Service Coverage Ratio

Mar 20, 2021 • 4 min read

Lenders use the debt-service coverage ratio (DSCR) to determine whether your business qualifies for a loan and under what terms. This is just 1 metric that financial teams consider (along with factors like your credit score and tax returns), but it is vital because it helps you get a fair rate and approval for your request.

## How Do You Calculate Your Debt-Service Coverage Ratio?

You can easily calculate your DSCR once you have your ledgers balanced and have developed a clear picture of the financial risks associated with your business.

This is the formula to track your debt-service coverage ratio:

Net Operating Income / Debt Service

For example, if you took out a \$20,000 loan and have a net operating income of \$30,000 for the year, your DSCR is 1.5 (\$30,000/\$20,000).

Once you calculate your DSCR, you can evaluate whether your income and proposed debt are proportionate or if you need to make changes to become profitable. Here is how you read the ratio:

• If your DSCR is greater than 1, you have the operating income necessary to pay off the debt.
• If your DSCR equals 1, you have just enough operating income to cover your debt.
• If your DSCR is less than 1, you do not have the operating income you need to cover your debt.

Continuing the example, if your business has to close for 6 months and you only have an operating income of \$15,000, a \$20,000 loan would place your DSCR at 0.75.

Most lenders prefer applicants to have a DSCR of at least 1.25. This creates a safe cushion in the event that a company’s net operating income decreases unexpectedly.

## What Is Net Operating Income?

As you learn about the debt-service coverage ratio, you may want to take a step back and learn about net operating income—an important term to help you calculate your DSCR.

Net operating income tracks a company’s ability to generate a positive cash flow. It is calculated by subtracting your operating expenses from your gross operating income (or revenue).

For example, someone who owns a real-estate rental property might collect \$1,000 each month in rent and \$75 monthly in fees for internet and utilities. The landlord would have \$1,075 in gross operating income. The operating expenses would include taxes, home insurance, and upkeep like a lawn service. If these expenses cost \$475 total, the landlord’s net operating income would be \$600.

## What Do Lenders Learn From Your DSCR?

The DSCR is an indicator of risk for your business loan. If you have a low DSCR (or a ratio that is close to 1), you are more likely to default on your loan. You may have to miss payments if you don’t maintain your net operating income or you may require additional loans to cover your costs.

A low DSCR can also cost your business money. Not only are you more at risk for a loan denial because of this ratio, but your lender may charge higher interest levels and have fewer forgiveness options if you get approved.

You could end up paying more fees and extra expenses to the lender in order to pay off the loan. Your lender might also require you to pay off the loan faster, limiting your other business investment opportunities.

## How to Improve Your DSCR

There are multiple steps you can take to improve your DSCR, but few offer easy solutions. You may need to make significant adjustments to your business to improve your financial standing. A few options include:

• Decreasing your operating expenses. (Lower payroll costs by adjusting your staff, cancel a few non-essential services.)
• Pay off some of your existing debt. (Wait a few months until your debt is lower to apply.)
• Decrease your borrowing amount. (Take out a smaller loan and apply again after you pay that one back.)
• Increase your net operating income. (Find ways to grow your sales without driving up costs.)

Each solution will have its own benefits for business owners. Some will find it easier to lower their borrowing amount, while others will want to cut expenses to get the funds immediately.

## Know Your DSCR Before You Apply for a Loan

You can reduce your risk of loan rejection by calculating your DSCR beforehand. You can understand how likely it is that your loan will get denied based on this score. A higher DSCR isn’t a guarantee for approval, but it can make your loan application look better.

Get to know some of the loan options through Lendio’s comparison guide. You can get an idea of the amount of funding you need and the flexibility required to spend the money how you want. Find what works for you today.

###### Derek Miller

Derek Miller is the CMO of Smack Apparel, the content guru at Great.com, the co-founder of Lofty Llama, and a marketing consultant for small businesses. He specializes in entrepreneurship, small business, and digital marketing, and his work has been featured in sites like Entrepreneur, GoDaddy, Score.org, and StartupCamp.

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