Debt service coverage ratio: Overview, definition, and example
What is the debt service coverage ratio?
The debt service coverage ratio (DSCR) is a financial metric used to evaluate a business's ability to meet its debt obligations (loan payments) with its operating income. It is calculated by dividing the business’s net operating income (NOI) by the total debt service (principal and interest payments) due within a given period, usually a year. A higher DSCR indicates that the business is generating enough income to cover its debt payments, while a lower ratio suggests potential difficulties in meeting debt obligations.
For example, if a business has an operating income of $200,000 and total debt service of $150,000, the DSCR would be 1.33 ($200,000 ÷ $150,000). This means the business generates 1.33 times the income needed to cover its debt payments.
Why is the debt service coverage ratio important?
The debt service coverage ratio is important because it provides lenders, investors, and business owners with insight into a company’s financial health and its ability to repay its debts. A DSCR greater than 1 means the company generates enough income to cover its debt payments, which is a sign of financial stability. A DSCR of less than 1 indicates that the business might struggle to meet its debt obligations, which can lead to financial distress or default.
For SMBs, maintaining a healthy DSCR is crucial for securing financing, managing cash flow, and ensuring long-term business sustainability. It helps businesses stay on track with their financial commitments and provides a buffer for unexpected financial challenges.
Understanding debt service coverage ratio through an example
Imagine your small business took out a loan of $100,000 with an annual payment requirement of $12,000 (principal and interest combined). In the same year, your business earns $25,000 in net operating income. To calculate the DSCR, you would divide the operating income by the debt service:
DSCR = $25,000 ÷ $12,000 = 2.08.
This means your business generates enough income to cover the debt payments more than twice over, which is a healthy DSCR indicating that you can comfortably meet your debt obligations.
In another example, if your business had the same loan but only earned $8,000 in operating income that year, the DSCR would be:
DSCR = $8,000 ÷ $12,000 = 0.67.
This indicates that your business does not generate enough income to fully cover the debt payments, and you would likely need to find other sources of funds or adjust operations to stay solvent.
An example of debt service coverage ratio in action
Here’s how DSCR might be referenced in a loan agreement or financial report:
“The borrower agrees to maintain a debt service coverage ratio of at least 1.25 to ensure the ability to meet debt obligations. If the DSCR falls below this threshold, the lender may require additional collateral or take other protective measures.”
Conclusion
The debt service coverage ratio is a critical metric that measures a business’s ability to cover its debt payments with operating income. For SMBs, maintaining a healthy DSCR is vital for managing cash flow, securing financing, and ensuring financial stability. A higher DSCR indicates a stronger ability to repay debt, while a lower ratio may signal potential financial struggles, prompting the need for adjustments in business operations or additional financial planning.
This article contains general legal information and does not contain legal advice. Cobrief is not a law firm or a substitute for an attorney or law firm. The law is complex and changes often. For legal advice, please ask a lawyer.