A business’s debt service coverage ratio (DSCR) is a convenient, concise way to express the company’s level of financial stability. The ratio compares the business’s annual net operating income (NOI) to its total debt payments for the year.
Specifically, a company’s yearly DSCR divides its NOI (revenue minus operating expenses) by its total debt outlay (payments toward principal and interest). Lenders often use this figure to assess real estate loan applications.
Read on for more details about this essential indicator of financial fitness.
Key Points
• The debt service coverage ratio (DSCR) measures a company’s financial stability by comparing its annual net operating income to its total debt payments for the year.
• Calculating DSCR involves dividing net operating income by total debt service, which provides a snapshot of your business’s ability to manage borrowing.
• A ratio greater than 1 means the business earns enough to cover debt obligations, while a ratio below 1 signals financial strain and the possibility of default.
• Most lenders prefer seeing ratios of at least 1.25, a number that demonstrates the company can handle unexpected expenses while meeting debt obligations comfortably.
• Lenders rely on the DSCR to evaluate creditworthiness and determine loan terms, with stronger ratios typically securing more favorable interest rates.
Why DSCR Matters for Businesses and Borrowers
Any business needs to earn enough to pay its expenses. The DSCR shows how easily the company can cover its current debt costs.
An owner might track their company’s DSCR to monitor their ability to take on additional small business loans. Or they might commit to keeping their company’s debt coverage ratio above a certain level to ease its dealings with lenders.
Lenders care about DSCR because it indicates whether a company has enough income to pay its debts. A company with a high ratio generally has stronger finances and thus less risk of default. Banks and other lenders are more likely to extend favorable loan terms and lower interest rates to a business with an ample financial cushion.
By the same token, a business with a low DSCR could end up paying higher interest on loans. The additional charge would be a lender’s equivalent of hazard pay, compensating the bank for its extra risk.
Commercial real estate lenders regularly consider DSCR when assessing loan applications. They want to be sure that the property being purchased can earn enough net income (through rents, for example) to pay its mortgage.
How DSCR Works
As noted above, the debt service coverage ratio expresses the business’s ability to service (that is, pay) its debt obligations.
One part of the ratio is the business’s annual net operating income (NOI) — that is, all the money brought in by the business, minus the cost of running it. The second part of the ratio is the business’s total debt payments for the year.
To calculate the ratio, you’d divide the former amount by the latter amount. The debt service coverage ratio formula is:
DSCR = Net operating income / Total debt service
A business with a DSCR greater than 1 earns enough net income to service its debts. For example, a DSCR of 1.25 means that a business has an NOI of $1.25 for every $1 of debt service, leaving a 25% surplus. The higher the DSCR, the bigger the company’s financial buffer.
By the same token, a DSCR below 1 indicates the company isn’t generating enough cash to cover its debt payments, signaling potential default risk. The business needs to increase income, reduce debt, or both.
DSCR Formula and How To Calculate It
To review, the debt service coverage ratio formula is:
DSCR = Net operating income / Total debt service
The two amounts needed for the DSCR formula are:
• NOI = Total revenue minus operating expenses. Yearly operating expenses typically include property taxes, insurance, service fees, and other costs.
• Total debt service = The annual sum of all principal and interest payments due
It’s important to note that NOI is similar to EBITDA (earnings before interest, tax, depreciation, and amortization), though not the same. Nor is NOI simply equal to revenue.
Like NOI, EBITDA shows a company’s profitability based on its core business operations. But NOI is generally used in real estate to evaluate income-producing properties, so it is less universal than EBITDA, which is most often used to measure how efficiently a company is operating overall and how it compares to competitors.
It can also be useful to compare revenue vs. EBITDA. The main difference is that revenue measures sales activity, while EBITDA measures how profitable the business is. Revenue is calculated by adding up income from all business operations, whereas EBITDA takes that revenue and then subtracts expenses in order to measure profit.
To find out your business’s DSCR, you can run the numbers with our Debt Service Coverage Ratio Calculator.
DSCR Calculation Example
To compute your business’s DSCR on the SoFi calculator, you’ll need to have certain figures at hand. As you can see on the calculator, these include:
Annual Income (Cash Flow)
• Your business’s annual NOI
• The depreciation and amortization amounts that were deducted on the business’s most recent tax return. This information is recorded on IRS Form 4562, Depreciation and Amortization, which you would have filed with the other forms in the return.
• Any other capital contributions or non-operating income infusions to the business. One caution: Because these cash injections probably don’t occur every year, you can’t necessarily assume they’ll be part of your annual DSCR in the future.
Annual Debt Service
• The total you pay each year in both principal and interest on your business loans and mortgages
• The annual total of your lease payments for property and equipment
• Principal and interest payments for any other debts on your books
The DSCR is a ratio, which means it can be calculated as a fraction.
To get the fraction’s numerator, the calculator will add up the figures listed under the heading Annual Income (Cash Flow). For the denominator, it will total all items listed under the heading Annual Debt Service.
Here’s an example to show how all of that comes together when you’re calculating the DSCR. Imagine your business records show the following:
| Annual Income (Cash Flow) | Amount |
|---|---|
| Annual NOI | $450,000 |
| Depreciation & Amortization | $50,000 |
| Other Cash Injections | $10,000 |
| Income Subtotal | $510,000 |
| Annual Debt Service | Amount |
| Annual Principal & Interest Payments | $150,000 |
| Lease Payments | $200,000 |
| Other Debt Obligations | $50,000 |
| Debt Subtotal | $400,000 |
In this case, we’d divide the income subtotal by the debt subtotal:
DSCR = $510,000/$400,000 = 1.28
Lenders generally consider a ratio of 1.25 or higher to be healthy.
What Is a Good DSCR?
Having a healthy DSCR assures banks and other lenders that your business can handle its debt obligations. Banks typically want to see a DSCR above 1, signifying that the company has more than enough working capital to pay its loans — but beyond that, there’s no single, universal benchmark. Different industries may have different standards for debt coverage ratios.
For instance, service industries (e.g., restaurants and breweries) may operate with lower DSCRs to allow for seasonal fluctuations. Professional firms, such as accounting or legal practices, can often have ratios on the higher side because their cash flow tends to be steadier, as it may come from retainers, subscriptions, and other recurrent charges.
That said, a DSCR of at least 1.25 tells lenders that the company can handle unexpected costs without falling behind on its debt payments. For SBA 7(a) loans, the desired DSCR is 1.15 or more.
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Why a Good DSCR Can Vary by Lender
In general, as discussed above, lenders prefer a higher DSCR because it signals less risk.
But just how high the DSCR needs to be is up to the lender to decide. Some banks can accept a higher level of risk and will lend to a company with a lower DSCR, where NOI barely outpaces debt service payments. Other, more conservative lenders will want an applicant to have a higher DSCR so that business setbacks are less likely to jeopardize the loan.
The specifics of a loan application affect the lender’s analysis, too. If a business’s sector, financial situation, or location are less stable, banks may expect higher ratios (say, 1.25 or more). A more predictable business with a lower DSCR may be able to get a loan due to the steadiness of its revenue.
Some other factors that could come into play are:
• Property type, if the business is purchasing real estate
• Type of loan program, such as a traditional mortgage vs. a non-qualified mortgage
• NOI specifics, as the lender may consider different income projections or additional operating expenses
Small business owners may also be asked for a global DSCR. This calculation is based on the owner’s personal income and personal debts, rather than those of the small business. Such information can be relevant when, say, a company applies for a startup business loan. A global DSCR could be additional evidence of financial responsibility and timely repayment of debt.
What Impacts DSCR?
As noted, some factors that could affect a business’s DSCR are:
• Its total revenues
• Its total operating expenses
• Which costs are included in operating expenses
• The cost (amount and interest rate) of the company’s current debt
Beyond the company’s financial specifics, overall economic conditions can also have an impact. A company’s DSCR might change noticeably depending on how the local or national economy is doing. Flush times could boost profits, increasing the DSCR. A downturn that reduces income might lead to a decrease in the DSCR.
How To Improve DSCR
In general, if your business cuts its costs and increases its revenue, you can expect its DSCR to improve. Increasing revenue might mean raising prices or offering additional services to customers. Cutting costs can be trickier. Here are three approaches that could help:
• Shrink operating expenses: Comb through your balance sheet and business checking records for ways to spend less. For example, negotiating volume discounts from vendors or flat-fee service contracts could bring down operating costs. Installing energy-efficient systems (e.g., smart thermostats) might save you money on the company’s power bill, lowering NOI. Changes in your spending levels could take effect within a month or so, depending on what actions you take.
• Explore refinancing your debt: If you can, look into lowering your debt payments through refinancing. This may involve extending the loan term or renegotiating for a lower interest rate. How soon this change could materialize depends on the success and speed of the refi process.
• Maximize tax benefits: There may be IRS or state provisions that could lower your taxes, thereby increasing your net operating income. This change could happen as soon as your next tax filing, if your company meets the requirements.
DSCR Mistakes To Avoid
When you’re calculating DSCR, mistakes can happen. One narrow example might be including revenue from isolated incidents (such as, say, an asset sale) in making your projections. Inaccurate cash flow estimates are likely to distort your NOI figure, so double-check that you’ve got all the correct numbers for the calculation.
Bigger DSCR errors can come from viewing your business situation too optimistically. This might mean overestimating projected NOI, underestimating expenses, or disregarding unfavorable market trends.
Exaggerating revenue estimates can lead to long-term financial problems. You may want to factor in extra cash reserves for unexpected costs or delays. To figure out how much you might need, you can stress-test your DSCR. Evaluate how well your business can sustain its debt service under different economic scenarios, such as a rise in interest rates.
Overall, your best bet for avoiding serious DSCR mistakes is to keep your income projections realistic and factor in all applicable expenses.
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The Takeaway
The debt service coverage ratio, known as DSCR, compares a business’s annual net operating income (NOI) to its total yearly debt payments. A DSCR greater than 1 means the business can cover its debt obligations, but lenders typically prefer a ratio of 1.25 or more, indicating an ample financial cushion. To improve its DSCR, a business could increase its NOI — by reducing operating expenses, say, or maximizing tax benefits — or reduce its debt service payments through refinancing.
If you’re seeking financing for your business, SoFi is here to support you. On SoFi’s marketplace, you can shop and compare financing options for your business in minutes.
FAQ
What is the debt service coverage ratio (DSCR)?
The DSCR is a comparison that indicates a company’s ability to make its loan payments. It’s calculated by dividing the annual NOI — which is revenue minus operating expenses — by the total debt outlay (that is, payments toward principal and interest). Expressed as a formula, DSCR looks like this:
DSCR = Net operating income / Total debt service
How do I calculate DSCR?
To calculate DSCR, divide the company’s annual net operating income (NOI) by its total debt payment for the year. If the two numbers match, the result equals 1. That means the business’s net income is just enough to service its debt.
A DSCR greater than 1 means the business earns more than it needs to pay out for its debt, signifying a lower risk of the company defaulting on its loans. A DSCR less than 1 shows that the business’s NOI is not enough to pay its loans, suggesting a higher risk of default.
What affects DSCR the most?
Many factors can impact a company’s DSCR. Arguably the most significant one would be the NOI, since that figure encompasses both revenue and expenses. As a result, the NOI is vulnerable to a wider set of potential problems. A change in NOI — declining revenue after losing a client, say, or rising expenses due to higher electricity costs — is likely to alter the ratio.
How can I improve my DSCR quickly?
Cost-cutting is likely to be the fastest way to improve your ratio. Three possible ways to do that are shrinking operating expenses, refinancing debt, and maximizing tax benefits.
Photo credit: iStock/Jacob Wackerhausen
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