Understanding your company’s debt service coverage ratio

April 11, 2011

No bank or other lender is going to loan you money for a long-term asset without knowing how you are going to prepay the loan. The debt service coverage ratio (DSCR) is used by banks and other lenders to determine how much free cash your business is generating that is available to repay a long-term loan.

As a business owner, you should learn about this ratio and understand how lenders use it when making business loans.

DSCR is the ratio of debt your company currently has and will have when the proposed loan is made to the net operating income (NOI) of your business. It is a ratio that is typically measured and projected on an annual basis. It is an effective measurement of your company’s ability to repay the proposed loan.

Before you can calculate the DSCR you must first calculate your company’s net operating income (NOI).

The first part of understanding NOI is that is the income from the total company once the proposed loan has been made minus the operating expenses the company currently has minus the proposed operating expenses. Here is an example NOI calculation:

Gross Income  
Current Income $1,000,000.
Additional Income after Loan $500,000.
Allowance for Contingencies (5%) (75,000)
Projected Gross Income $1,425,000.
   
Operating Expenses1,2  
Cost of Goods Sold $926,250.
Sales, General and Administrative $285,000.
Total Operating Expenses $,1211,250.
Net Operating Income (NOI) $213,750.

1 Operating expense categories have been simplified for easy understanding.
2 Interest expenses are not included in the NOI calculations.

Once you have computed your NOI, it is necessary to compute your current and proposed amounts for loan repayment (debt service)

Current loan  
Loan Balance (26 mo remaining) $66,170.
Monthly Payment $2,545.
Annual Payment Total $30,540.
   
Proposed Loan (5 year,15 year amortized)  
Loan Amount $925,500.
Interest Rate: 6.00%  
Monthly Payment $7,810.
Annual Payment Total $93,720.
   
Total of All Loan Repayments $124,260.

Here is the DSCR calculation: NOI/Annual Debt Service = DSCR

In our example the calculation looks like this: $213,750 / $124,250 = 1.72

A DSCR of 1.0 means that the business can afford exactly the same amount of debt as it has cash to support it, with no safety cash.

In today’s economy, lenders are seeking a DSCR of at least 1.25 or greater. In my example above, the loan does adequately “debt service” since it has a DSCR of 1.72. If I had done this exercise assuming the asset being financed was on a 15 year straight amortization at the same interest rate as above, the monthly payment would be within a few dollars of the figure I used, so the DSCR would remain the same.

Topics: Management, Accounting & Finance

Mary Ann Hebel

Business Bank of Texas

Mary Ann Hebel is organizer, director, executive vice president and chief financial officer of Business Bank of Texas, N.A. With over 37 years of banking experience, Mary Ann has contributed to the success of three national banks in the areas of accounting, data processing, human resources, and more recently as chief operations and chief financial officer. Mary Ann has also served as a consultant to the Texas Department of Banking in the capacity of liquidation agent for failed trust companies and private banks.
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