A Debt to Service Coverage Ratio, or DSCR, is a measurement of a company’s ability to pay its debts compared to its operating income (not net income) and is used by anyone evaluating a company’s ability to make payments including commercial lenders, investors, business owners looking to expand, and companies that lease or offer equipment financing.
A ratio of 1.0 is the break-even point, meaning the business has exactly enough income to cover its debt. If the company takes any type of small business loan, line of credit and carries a balance, or other recurring expense, their number will decrease, making their chances for an approval more difficult.
DSCRs over 1.0 mean the company has more income than debt and are a safer option for investors, lenders, or leasing companies. A score under 1.0 means the borrower is a risk, as they do not have the operating income to cover their recurring monthly expenses.
The average baseline a lender may use is 1.25. They’ll likely want the loan amount to not lower the borrower’s debt to service coverage ratio below 1.0. Here’s how to calculate your DSCR and improve it before you apply for a lease, a loan, or any type of financing.
Calculating Your DSCR
The Debt to Service Coverage Ratio is calculated by dividing Net Operating Income (your total revenue minus daily operating expenses, not including interest, taxes, depreciation or amortization) by Total Debt Service (loan payments, lease payments or interest).
DSCR = Total Net Operating Income/Total Debt Service
Your total debt service can be found by adding together all of your monthly bills including rent, utilities, software subscriptions, insurance payments, etc. Next, add up your net operating income which includes your total income each month and can be found on either your Income Statement or your Profit & Loss Statement (P&L).
If you have a net operating income of $100,000 and your total monthly debt payments are $30,000, your DSCR is 3.33 and you have more than twice your operating income available to make payments, you are a good candidate.
$100,000/$30,000 = 3.33
When your net operating income is $50,000 and your total monthly debts are $65,000, your DSCR is .76 and you’re a high risk.
$50,000/$65,000 = .76
But a lower number than 1 may not be as bad as it appears depending on your NAICS code or industry. A real estate investor that just purchased two new properties and is in contract to sell two others may have a number lower than 1, but it will go back above 1.0 shortly. Same with a franchise owner expanding and the new store will become profitable in a couple of months.
The industry you are in can matter almost as much as your number, and knowing how to improve yours will help you whether you’re looking to invest back into your own company, take a loan, or bring on equity partners.
Ways to Improve Your DSCR
The two ways to improve your debt to service coverage ratio are to reduce your total monthly recurring expenses or increase your EBITDA.
Reducing Recurring Monthly Expenses
The first and easiest way to reduce your total monthly expenses is by clearing any balances on existing debts like credit cards, lines of credit, and business loans (especially when there are no penalties for curtailments). If you don’t have cash-on-hand, try combining multiple types of debt financing via a debt consolidation loan.
The amount you take with the loan can pay off the balance on a business credit card and business line of credit, and combine in any other type of small business loan you have. Even if the monthly payment is the same, the interest could be lower than each being paid separately which reduces your total monthly costs.
Pro-tip: If you have a merchant cash advance, see if you can use the debt consolidation loan to clear it instead of making the weekly, monthly, or recurring payments to the lender.
Refinancing a business loan extends the payback period while lowering your monthly expense. The lower recurring monthly cost improves your debt to service coverage ratio, same with renegotiating the terms of a business credit card. If you have a balance on the card and a different one with equal benefits but a lower interest rate comes along, you may want to close the current card and move to the new one while paying off or transferring the balance.
If you rent a large space for your office or warehouse and don’t need all of it, see if you can sublease it to another company or vendor. This way you share the expense with them, and likely the utilities and other fees associated that count as monthly recurring expenses. If they turn out to be complementary to your company, they may be able to refer business, increasing your operating income and also improving your DSCR.
One last thing to do is check for smaller opportunities that add up to larger amounts including going from monthly software subscriptions to annual payments that likely have a discount.
Increasing Your Operating Income
Anything you can do to bring more operating income to your business will help improve your debt to service coverage ratio. Start by looking for any unnecessary expenses like premium brands for snacks in the breakroom and business trips that you don’t need to take, only want to take. Next look for ways to upsell add-ons and upgrade packages.
These could be bundle deals that increase profit and revenue while clearing shelf space, so you can restock and move more inventory, or cross-selling complementary products a customer may not know you have.
Launching subscriptions can be a good way to increase your net operating income and provide a consistent stream of revenue. It could be monthly house checks and maintenance for service providers or a soap and scent of the month for candle and soap companies. If you have a consumer good that is a subscription, see how you can work with subscription reviewers on YouTube, TikTok, and websites as they can bring you new subscribers regularly via an affiliate program, influencer deal, or advertising buy.
Ecommerce stores with high volumes of traffic have the ability to run an ad network post check out to bring in ad revenue. Just make sure you don’t funnel or leak customers away via the ads if competitors buy the space.
Brick and mortar stores that have slow days on a predictable basis can host a pop-up vendor that rents a table to sell their products for a day or three. In addition to increasing the revenue from the rented space, the pop-up shop might bring new customers to the store and increase sales.
When you haven’t updated your pricing in a while, it could be time to test an increase on top sellers or low-cost but high-volume products. If customers are not very price sensitive on these products, this will increase your net operating income without you having the headaches of manufacturing, stocking, and marketing new products and services.
A good debt to service coverage ratio is any number over 1.25, and a bad one is under 1.0. To improve yours, you’ll need to reduce your total monthly recurring expenses or increase your net operating income. Both are easy to do when you look at where your company can save on expenses and discover ways to grow your revenue.
SmallBusinessLoans does not provide tax, legal or accounting advice. This material has been prepared for informational purposes only. You should consult your own tax, legal and accounting advisors.
