Understanding Debt Service Coverage Ratio For Business Loans

When applying for commercial loans, lenders evaluate various metrics to assess your eligibility. Among these, Debt Service Coverage Ratio (DSCR) holds significant importance as it answers the key question: Can you repay the loan in full and on time? Your company's DSCR helps lenders determine your loan qualification, size, and conditions. Calculating DSCR involves more than just plugging in numbers; understanding the interpretation and factors involved in this calculation is crucial. So let's understand DSCR in this article.

What Is DSCR?

The DSCR (Debt Service Coverage Ratio) is a vital indicator which financial institutions use to evaluate a company's capacity to meet its debt obligations. It is calculated by dividing the entity's net operating income by its total outstanding debt. This ratio provides valuable insights into the entity's capacity to repay its debts and applies to various sectors, including government, corporations, and individuals. Including principal obligations in the denominator makes DSCR particularly valuable for entities with reducing term debt in their capital structure (i.e. annual or monthly principal repayments).

How To Calculate DSCR?

To compute DSCR, the formula used is-

DSCR= Net operating income/ Total outstanding debt (i.e. debt service)

Here, the debt service includes the principal debts to be repaid and the interest component paid during the year. Some companies also consider lease payments as a part of the total outstanding debt.

For computing the net operating income, subtract your operating expenses from the total revenue or income generated from the sale of services or products. Some companies consider EBITDA (i.e. earnings before interest, tax, depreciation and amortization) and EBIT (earnings before interest and taxes) instead of net operating income. In this case, the formula used for the computation of each term will be-

EBITDA= Pre-tax income + Interest + Depreciation and Amortisation

EBIT= Net income + interest + taxes

To get the formula's total revenue and other component figures, you will have to refer to your accounting reports.

How Does DSCR Work?

Say your company's annual revenue is Rs.80,000, and Rs.30,000 is shelled out for operating expenses. That gives us a net operating income, which is Rs.50,000. Now, the company pays Rs.500 towards business loans and Rs.1,500 towards mortgages monthly, making it a debt payment of Rs.24,000 per year. A lease component paid out annually totals Rs.6000. Thus, we get a debt service of Rs.30,000.

Now, to compute DSCR,

DSCR= Net operating income/ Total outstanding debt = 50000/30000 = 1.667 times.

The ratio is then measured keeping ‘1’ as the break-even score, where the interpretation of DSCR is as follows-

• If the DSCR is below one, the borrower may not be able to meet debt payments, indicating negative cash flow. Lenders may require proof of alternative cash flow sources before approving the loan. For example, a DSCR of 0.68 means the borrower can cover 68% of their debt payments and needs additional funds for the remaining 22%.
• If the DSCR is 1, the borrower can meet their debt payments. However, loss of any significant customer or sale channel can risk the chances of non-payment. So, lenders usually require maintaining a specific DSCR for the loan term.
• A DSCR above one indicates sufficient cash flow to cover debt payments. Lenders prefer a DSCR between 1.2 to 1.4, while a ratio of two or higher is considered ideal.

In our example, the ratio was 1.67 times, which means, you are likely to get a business loan for your company.

Can I Use Interest Coverage Ratio Instead Of DSCR Ratio?

The Debt Service Coverage Ratio (DSCR) measures the entity's ability to meet all current obligations, while the Interest Coverage Ratio assesses its ability to pay interest on debt. A good DSCR considers both principal and interest, while the interest coverage ratio focuses solely on interest. However, if the loan requires only interest payment, the interest coverage ratio is more relevant than DSCR.

Importance Of DSCR:

1. DSCR provides a better assessment than liquidity or leverage ratios, which can be misleading.
2. Assessing DSCR helps banks avoid granting loans to entities unable to repay in full.
3. DSCR is particularly significant in real estate loans, as it considers property revenue instead of personal income.
4. Buyers without recurring income may qualify if the property generates enough revenue to cover the loan amount.

Conclusion:

The debt service coverage ratio (DSCR) is crucial for small businesses seeking funds. Lenders use it to assess loan affordability and borrowing capacity. Additionally, DSCR indicates financial health and cash flow for your company, helping determine loan feasibility. In case of a higher DSCR, loan is most likely to get approved as it reflects a stronger position for borrowing. So, if the DSCR is suitable to get a loan easily and you are looking for a trusted brand, turn to IIFL Finance and get your small business loan quickly with complete transparency.