What Is Debt-Service Coverage Ratio? | Bankrate (2024)

Key takeaways

  • Debt-service coverage ratio (DSCR) looks at a company’s cash flow versus its debts.
  • The ratio is used when gauging a business’s ability to pay off current loans and take on future financing.
  • If your DSCR isn’t high enough, you can improve it by upping your income or lowering your debt.

In a business context, debt-service coverage ratio (DSCR) is a metric that compares a company’s cash flow against its debt obligations. Business owners and investors can use DSCR to understand if the company is generating enough net operating income to cover existing debts, including principal and interest.

DSCR can help inform future business decisions, including whether a company has the financial ability to repay its existing business loans and take on further debt. It also helps lenders assess the strength of business loan applications and how much risk they’ll take on by lending to you.

How to calculate debt-service coverage ratio

There are two main components in how to calculate DSCR: a company’s annual net operating income and its annual debt service. The formula for determining a company’s DSCR is:

Net operating income / Debt service

So, how do you calculate each of these components? For net operating income, you’ll want to look at the business’s pre-tax revenue minus operating expenses, such as wages, rent and cash taxes, for a given period:

Net operating income = Revenue – Operating expenses

Debt service, on the other hand, is the total of all existing debts owed by the company due in the same period. This should include all interest and principal.

It’s important to note that some lenders and financial professionals use different versions of this formula to calculate DSCR. For example, the Corporate Finance Institute (CFI) outlines the DSCR formula using EBITDA — short for earnings before interest, taxes, depreciation and amortization — in place of net operating income. If you’re calculating DSCR to understand your company’s income vs. debts, make sure to be consistent with the formula you choose.

As an example, let’s say that your business has an annual net operating income of $100,000, with a total debt service of $50,000. In that case, your DSCR would be 2, meaning that you can cover your current debt twice over. Later, we’ll explain what this means — and how you can work on increasing your DSCR if need be.

Why does DSCR matter?

On a basic level, tracking your DSCR lets you understand the financial health of your business. It provides a concrete number — rather than a general idea — to help you assess the gap between how much money you’re bringing in and how much is going toward debt.

For lenders, having a strong DSCR indicates that your business has figured out how to balance revenue generation with debt repayment. If you’re hoping to get a new loan (and favorable terms), it’s essential to prove that you have the resources to pay it back.

What’s a good DSCR?

You want to aim for a higher DSCR rather than a lower one, but lenders will determine their own requirements for what qualifies as a good DSCR. They’ll also take into account things like your industry and company age when evaluating your DSCR as part of a loan application.

Current economic conditions matter, too: Lenders might require a higher DSCR from potential borrowers at times when the economy is rocky, and many businesses are defaulting on loans.

Still, there are some basic things to keep in mind when thinking about what makes a good DSCR. For starters, having a DSCR of 1 shows that all of your net operating income will need to go toward debt. Obviously, that’s not a good sign for your company’s financial health or loan chances.

According to the CFI, most lenders will expect to see a DSCR of at least 1.25, but ideally, closer to 2. A better DSCR — especially paired with other indicators of financial health, such as a high business credit score — may mean a lower interest rate.

How to improve your DSCR

Since your DSCR is all about how your income compares to your debt, you’ll need to work on increasing profits or reducing debt (or, better yet, both) in order to raise your DSCR. Of course, these are areas of your business that you’re likely already focused on, so you may need to take a slightly different approach.

Instead of figuring out how to increase sales, think about how to cut certain expenses. For instance, can you negotiate with vendors to lock in lower prices? Can you trim utility or labor costs? In terms of debt reduction, are you able to refinance your current loans and lock in a lower rate?

The bottom line

Whether you’re preparing to secure another round of financing or you just want to take a better look at your company’s financial well-being, understanding DSCR’s meaning is a useful exercise. If it’s not quite where it needs to be, there are ways to improve it. Start by turning your efforts toward driving revenue while reducing expenses and existing debt.

Frequently asked questions

  • Most lenders want to see a debt-service coverage ratio of at least 1.25. But, lender requirements will vary depending on the type of business loan and lender you select.

  • Yes, a higher DSCR is better. While a DSCR of 1.25 is the minimum requirement for most lenders, a higher number — such as 2 — shows lenders you are financially stable and can repay your debts. A higher DSCR can also mean a potentially lower interest rate as lenders see you as less of a risk for defaulting on your business loan.

  • To increase your DSCR, you’ll want to look at lowering the amount of debt your business has and increasing profits. If increasing sales is something your business is struggling with, you can look at ways to cut costs in your business’s budget.If you’re having difficulty paying down debt, consider refinancing or consolidating your business loans.

What Is Debt-Service Coverage Ratio? | Bankrate (2024)

FAQs

What Is Debt-Service Coverage Ratio? | Bankrate? ›

In a business context, debt-service coverage ratio

debt-service coverage ratio
July 2022) The debt service coverage ratio (DSCR), also known as "debt coverage ratio" (DCR), is a financial metric used to assess an entity's ability to generate enough cash to cover its debt service obligations, such as include interest, principal, and lease payments.
https://en.wikipedia.org › wiki › Debt_service_coverage_ratio
(DSCR) is a metric that compares a company's cash flow against its debt obligations. Business owners and investors can use DSCR to understand if the company is generating enough net operating income to cover existing debts, including principal and interest.

What does a DSCR of 1.25 mean? ›

If your debt service coverage ratio is 1.25, or 125%, that means your net operating income is 125% of your debt obligations. In other words, you can pay all your debts, with additional cash left over.

What if DSCR is more than 2? ›

DSCR > 2: When a company's DSCR is above 2 then the company is able to cover at least double its debt obligation amount. A high DSCR ratio suggests a healthy cash flow operation and a low debt risk profile.

Is a higher or lower DSCR better? ›

As a general rule, however, a DSCR above 1.25 is often considered “strong,” whereas ratios below 1.00 could indicate that the company is facing financial difficulties.

What is a 30 year DSCR? ›

WHAT IS A DSCR LOAN? A Debt-Service Coverage Ratio (DSCR) loan is based upon cash flow from rental income. Approval for the 30-Year Rental Loan will occur if there is enough cash flow from the rental income received on a particular property to cover the outstanding monthly debt on the property.

What does a DSCR of 0.5 mean? ›

Conversely, a ratio below 1 is not a good sign because it means that the company is unable to service its current debt commitments. For example, if a company has a DSCR of 0.5, then it is able to cover only 50% of its total debt commitments.

Is a 1.5 DSCR good? ›

Different types of lenders have different requirements for minimum debt service coverage ratio — there is no universal industry standard. That said, a DSCR of 1.25 to 1.50 is a typical minimum for most lenders, while a DSCR of 2.0 would be considered very strong.

Is a DSCR of 3 good? ›

A ratio of 2 or higher is generally seen to be healthy. “If you're at 1, all of the EBITDA you earn is going straight to debt,” Sood says.

What is the ideal average DSCR ratio? ›

If the DSCR is much greater than 1, like 1.6, this means that the borrower has enough cash flow to cover their debt payments. Each loan is unique and has its own DSCR minimum, but most lenders want to see a DSCR minimum of 1.2 to 1.4, with a ratio of 2.0 or higher being the most ideal.

What's the lowest can get on DSCR? ›

Minimum DSCR of . 75: Typically, lenders require a minimum DSCR ratio, often around 1.25 to ensure that the property generates sufficient income to cover its debt obligations. While the average DSCR of our borrowers is 1.05, Griffin Funding accepts DSCRs as low as . 75.

Can you get a DSCR loan with no money down? ›

Down payment: DSCR loans typically require a down payment of 20-25% of the purchase price. However, some lenders may offer lower down payment options to borrowers with strong credit and experience with investment properties.

What is a good DSCR for rental property? ›

Most DSCR lenders want to see a minimum ratio of 1.2 or 1.25. This assures them that you won't miss a payment if your rental property experiences unexpected vacancies or needs a sudden repair. A debt service coverage ratio of at least 2.0 is considered very strong and is a great goal to aim for as an investor.

How many times can you use a DSCR loan? ›

In addition to the DSCR ratio, investors may also have to meet certain credit score credit score requirements or even offer a down payment, though the exact requirements vary between lenders. There is no limit to the number of DSCR loans you can qualify for.

Can you use a DSCR loan for a primary residence? ›

No, DSCR loans can only be used to purchase income-generating properties. This type of financing is suited for real estate investors rather than those seeking out a primary residence.

Can I refinance a DSCR loan? ›

Yes! You can absolutely refinance a DSCR loan, though you will want to make sure you will not be incurring an expensive prepayment penalty.

What is a DSCR of 1.2 ratio? ›

The higher the ratio, the more debts a company can take on and is capable to pay, making it more attractive to lenders. From the example above, a DSCR of 1.2 would indicate that the property is making 120% of what is needed to service the debt.

What is a 1.2 DSCR? ›

If the DSCR is 1.2, that means the property can cover its total debt 1.2 times over the current year.

Is DSCR 1.15 good? ›

In most cases, a lender will look for a minimum DSCR of at least 1.15, which indicates that based on current net operating income, the business would be able to repay any loan with interest.

What does a 1.5 DSCR mean? ›

DSCR = 1.5

This means that the company generates 1.5 times the income needed to cover its debt obligations. A DSCR greater than 1 indicates that the company has sufficient income to meet its debt payments, which is generally viewed positively by lenders.

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