Hi, I’m Priyanka Prakash, senior staff writer
at Fundera. When applying for a business loan, one phrase
you’ll hear a lot is debt service coverage ratio or DSCR. Lenders basically use DSCR to figure out if
you are financially able to pay back the loan that you’re applying for, as well as any business
loans that you might already have. Today, I’ll walk you through the DSCR formula,
as well as a few examples, so you know exactly how to meet this requirement when you apply
or NOI, should be about 1.1 to 1.2 times higher than your business’s debt payments, as this
graph indicates. We’ll talk more about lenders specifics in
a second, but first I’m going to show you the DSCR formula. The DSCR formula actually isn’t too complicated. You simply take your business’s annual net
operating income and divide it by your business’s annual debt payments. Now, most lenders look at DSCR on an annual
basis, so you should as well, but if you’re applying for a short term loan, it might be
better to calculate DSCR on a monthly basis or quarterly basis. Just make sure you’re comparing apples to
apples. For example, for annual DSCR, you divide annual
NOI by annual debt payments. For a quarterly DSCR, you would divide quarterly
NOI by quarterly debt payments, and for a monthly DSCR, you would divide monthly NOI
by monthly debt payments. Okay, now that we have the formula, let’s
look at a basic example. Let’s say you’re applying for a business loan
for your restaurant and your annual NOI is \$100,000. Let’s say that you also have \$75,000 in total
business loans. That might be \$25,000 in existing debt and
\$50,000 of new debt that you’re applying for. However the breakdown, I’ve emphasized “all”
here to remind you that you should take existing debt and new loans into account. And for simplicity, let’s say that this \$75,000
includes the loan principal and interest. To calculate DSCR, you would simply take your
\$100,000 of annual NOI and divide it by your \$75,000 of annual debt payments to get a DSCR
of 1.33. We’ll talk about whether this is a good DSCR
in just a minute, but first I want to cover a couple of other ways of looking at DSCR. Suppose you know what the lender’s minimum
required DSCR is. For example, maybe you found this information
on the lender’s website or asked them about their specific requirements, and they told
you that their minimum DSCR was 1.15. Assuming you have the same \$100,000 of business
NOI, you can flip the formula, dividing \$100,000 by the 1.15 DSCR, which gives you \$86,957
in annual debt payments. This is your maximum annual debt service,
which means your yearly loan payment should be no higher than \$86,957 when including for
both principal and interest. Finally, you can take this a step further
by calculating the maximum monthly payment on your loan. Take the maximum annual debt service from
the previous example, and divide by 12 months in a year to get a maximum monthly loan payment
of \$7,246. If a lender charges payments on a weekly or
bimonthly basis, you would simply divide the debt service by the number of those periods
in one year to get the maximum payment. So now that you’ve calculated DSCR, you’re
probably wondering, is your DSCR good? And will you be able to qualify for the loan
that you’re applying for? Let’s look at that next. What makes a good DSCR? Well, as I alluded to earlier, most lenders
prefer a DSCR of 1.1 or higher. If you have a DSCR greater than one, you’re
in a good spot because it means that you can comfortably cover your debt payments with
your current net operating income. A DSCR of one means that you’re breaking even,
so you have just enough cash to cover your debt payments, but not much wiggle room. If you make lower than expected revenues for
the year, or if you lose a big client, you could wind up in the negative and you could
be unable to pay back your loan. Lastly, if your DSCR is below one, that means
you cannot afford the loan payments. Given your current net operating income. Global DSCR is a variation on regular DSCR
that many small business owners aren’t familiar with. Global DSCR is different because it includes
your personal income and personal debt in addition to business income and business debt. Let’s take a look at an example. Let’s say that you run a restaurant with an
annual net operating income of \$100,000, but you also have a personal day job that brings
in \$40,000 per year. In terms of debt, you have your \$75,000 of
business debt, but you also own a home and have a balance on your mortgage of \$55,000. When you add up the income in the numerator
and the debt in the denominator and divide, you get a DSCR of 1.8. If you remember our previous example when
we looked just at business NOI and business debt, we had a DSCR of 1.33. As this example shows, global DSCR will typically
be lower than regular DSCR, especially if you have a significant amount of personal
debt. But, lenders also have lower requirements
for global DSCR because they understand that you might be coming to the table with some
personal loans. Now, we mentioned before that you should check
in with your lender about their required DSCR minimum. This is a good idea because if you don’t meet
the requirements, you should focus on improving your DSCR instead of starting in on a long
application process. DSCR relies on two factors–income and debt–so
you can make improvements from either of those two angles. On the one hand, you can try to increase your
revenue. For example, you might be able to cut costs
or bring on a new client or find some other way to generate more income. On the other hand, you can try to minimize
debt levels. That might mean trying alternatives to debt
when raising capital or refinancing existing debt with a lower interest loan. And that’s our explanation of debt service
coverage ratio or DSCR. If you have more questions related to small
business lending, we have a wealth of information at fundera.com/blog. You can also subscribe to our YouTube channel