How to calculate your debt service coverage ratio (DSCR) and why it matters

For small businesses, managing finances effectively is key to securing loans and maintaining healthy cash flow. One critical metric lenders use is the debt service coverage ratio (DSCR), which uses a business's available cash flow to measure its ability to cover debt obligations.

Understanding the debt service coverage ratio formula is essential for any of the 5,000 small businesses navigating their finances. A strong DSCR boosts lender confidence and helps business owners evaluate their financial standing and plan for sustainable growth.

Whether you’re seeking financing or simply aiming to improve your financial strategy, mastering the DSCR can make a significant difference. In this article, we’ll break down how to calculate the debt service coverage ratio, explain what constitutes a healthy score, and explore how lenders use this metric to determine loan terms.

Breaking down the debt service coverage ratio (DSCR)

What DSCR tells you about a company’s financial strength

Why DSCR matters to lenders and investors

DSCR vs. interest coverage ratio

Pros and cons of using DSCR

An example of how to calculate DSCR

Next steps for managing your cash flow

Breaking down the debt service coverage ratio (DSCR)

The debt service coverage ratio is a straightforward yet powerful metric for assessing a business’s ability to repay its debts. You can calculate it by dividing net operating income (NOI) by total debt service, which includes both principal and interest payments. 

DSCR = Net Operating Income / Total Debt Service 

This formula provides lenders and business owners with a clear picture of cash flow relative to debt obligations (or current liabilities).

To accurately calculate DSCR, you'll need to understand the two key components: net operating income and total debt service. Each plays a critical role in determining whether your business can comfortably meet its financial commitments. Let’s dive deeper into these terms and how to estimate them.

What counts as net operating income

Net operating income (NOI), the numerator in the debt service coverage ratio formula, represents the revenue left after covering operating expenses but before accounting for taxes and interest. 

Nonoperating Expenses = Gross Operating Income - Operating Expenses

To calculate NOI, start with your total revenues and subtract operating expenses such as rent, utilities, payroll, and supplies. Exclude nonoperating costs like taxes, interest payments, or one-time expenses. 

This metric focuses on core operations, providing a clear view of your business’s profitability while offering the necessary context you need to reduce operating costs.

Understanding total debt service

Total debt service, the denominator in the debt service coverage ratio, includes all scheduled payments due within a year, such as principal, interest, leases, and recurring debt expenses. 

Special considerations like sinking funds or balloon payments may also factor in. Lenders analyze total debt service to assess financial obligations, helping evaluate your ability to manage debt and meet expectations.

Adjusting for taxes

For a more accurate debt service coverage ratio (DSCR) calculation, adjust for taxes on interest payments to reflect their tax-deductible nature. Since interest payments are typically tax-deductible, they reduce a company's taxable income, lowering the actual cost of the interest expense. 

Factoring in this tax benefit allows for a more precise cash flow statement, which can help you assess your ability to pay off debts accurately. 

This adjustment also ensures a clearer comparison across companies or industries with differing tax rates and offers a more realistic view of a business’s debt repayment capacity, helping lenders and stakeholders make informed decisions.

What DSCR tells you about a company’s financial strength

The debt-service coverage ratio (DSCR) measures a company’s ability to pay its debt obligations using operating income, indicating whether it generates enough cash flow to cover loans, leases, and other debt expenses. 

Different DSCR levels carry significant implications. A DSCR below 1.0 indicates that a company’s operating income isn’t sufficient to cover its debt payments, signaling high risk. 

A DSCR of exactly 1.0 means the business is breaking even on debt obligations but has no room for error. A DSCR above 1.0 demonstrates the ability to comfortably cover debt, with higher ratios like 2.0 or more reflecting strong financial health.

With this context, let’s ask, what does a 1.5 DSCR mean? It indicates a reasonably strong financial position, a business not necessarily drowning in cash but able to service its debts on time.

Why DSCR matters to lenders and investors

​​The debt-service coverage ratio (DSCR) is pivotal in credit assessments and loan agreements, serving as a key metric for lenders and investors evaluating financial risk. 

Lenders use the DSCR to determine whether a business can generate enough cash flow to meet its debt obligations. This analysis directly impacts loan eligibility, interest rates, and borrowing terms.

For lenders and investors, the DSCR evaluates credit risk—a high ratio suggests sufficient income to avoid default, while a low ratio signals potential cash flow problems.

Lenders often include DSCR covenants in loan agreements, requiring borrowers to maintain a minimum ratio to avoid penalties or default triggers.

Minimum DSCR requirements

Lenders typically set benchmark DSCR requirements to ensure borrowers can manage their debts effectively. 

Common thresholds range from 1.2 to 1.25, meaning a business must generate at least 20-25% more operating income than its total debt service. This is an important threshold to be aware of. These benchmarks provide a buffer to account for unexpected fluctuations in cash flow.

A DSCR of 2.0 or higher is very strong, indicating that a company can cover its debt obligations twice over. However, acceptable DSCR levels can vary by industry and borrower profile. 

For instance, capital-intensive industries may have lower expectations due to higher inherent risks, while stable sectors might demand stricter standards. 

Understanding these benchmarks helps businesses align their financial strategies with lender expectations and improve their chances of securing favorable loan terms.

DSCR vs. interest coverage ratio

While both the debt-service coverage ratio (DSCR) and the interest coverage ratio assess a company’s ability to meet financial obligations, they serve different purposes. The key distinction lies in what each metric measures. 

The interest coverage ratio focuses solely on a company’s ability to pay interest expenses, ignoring principal payments. In contrast, the DSCR provides a more comprehensive view by factoring in both principal and interest, offering a fuller picture of debt repayment capacity.

When to use each metric

Choosing between these metrics depends on your goals and the specific financial insights you need. The debt service coverage ratio is the ideal choice for long-term financial analysis or loan assessments. 

For example, a lender evaluating a small business loan application will prioritize the DSCR to ensure the borrower can cover all debt obligations over time. Similarly, business owners planning for sustainable growth should monitor their DSCR to maintain healthy cash flow and meet loan covenants.

The interest coverage ratio, however, shines in scenarios where short-term liquidity is the focus. For instance, if a company wants to assess its ability to handle interest payments during a seasonal dip in revenue, this metric can provide valuable clarity. 

By understanding when to use each ratio, businesses can make informed decisions tailored to their unique financial needs.

Pros and cons of using DSCR

The DSCR is a powerful tool for evaluating a company’s financial health, but like any metric, it has its strengths and limitations.

Benefits of DSCR

The DSCR provides several key advantages for businesses and lenders alike. It's invaluable for tracking financial trends over time and comparing performance against competitors. It offers a conservative measure of cash flow relative to debt obligations, making it a reliable indicator of long-term stability. 

Main DSCR benefits:

• Useful for financial trend analysis: By calculating DSCR on a rolling 12-month basis, companies can identify patterns in their debt and cash flow management, helping them address issues proactively.
• Offers peer benchmarking opportunities: The DSCR allows businesses to compare their financial performance with competitors in the same industry, providing context for their operational efficiency.
• Provides a conservative measure of financial health: Since it considers both principal and interest payments, the DSCR offers a more comprehensive view of debt repayment capacity than simpler metrics.
• Often calculated on a rolling 12-month basis: This approach smooths out seasonal fluctuations, offering a clearer picture of sustained financial performance.

Limitations of DSCR

Despite its strengths, its reliance on accounting methods and exclusion of certain expenses, like taxes, can limit its accuracy in some scenarios. 

Let’s explore these aspects in more detail:

• May overlook tax liabilities and other real expenses: Because the DSCR focuses on operating income, it doesn’t account for taxes or other nonoperating costs, which can skew the true financial picture.
• Relies heavily on accounting rules: Variations in calculating net operating income, such as using EBIT or EBITDA, can lead to inconsistent results across companies or industries.
• Complex compared to simpler ratios: Unlike metrics like the interest coverage ratio, the DSCR requires more detailed calculations, which can be challenging for small business owners unfamiliar with financial analysis.
• Varies across lenders and industries: Different lenders and industries may have varying standards for what constitutes an acceptable DSCR, making it harder to generalize its application.

By weighing these pros and cons, businesses can leverage the DSCR effectively while remaining mindful of its limitations in specific contexts.

An example of how to calculate DSCR

​​Seeing the debt-service coverage ratio (DSCR) in action helps clarify its importance and real-world applications. Let’s explore a numerical example to consider how it influences loan eligibility and financial stability.

Imagine a real estate developer with a net operating income of $214,000 and total debt service of $100,000 annually. 

Using the formula, their DSCR is 2.14. This high ratio indicates strong financial stability, as the developer generates more than six times the cash needed to cover debt obligations. 

Lenders would view this as low risk, making the developer an excellent candidate for favorable loan terms. 

Sample loan terms based on DSCR

The DSCR directly impacts lending decisions, influencing interest rates, loan-to-value (LTV) ratios, and other terms.

A higher DSCR both improves loan eligibility and secures better terms, reducing borrowing costs and increasing flexibility.

DSCR in loan agreements

In loan agreements, the DSCR often appears as part of financial covenants, ensuring borrowers maintain a minimum level of cash flow to cover debts. 

For instance, consider a loan agreement with Sun Country Inc., where the lender stipulates a minimum DSCR of 1.20. If Sun Country’s DSCR drops to 1.10 due to unexpected expenses, the lender might require the company to allocate a portion of its revenue toward debt repayment until the ratio recovers. 

These covenants protect lenders while encouraging borrowers to prioritize financial stability.

Next steps for managing your cash flow 

The debt-service coverage ratio (DSCR) is a cornerstone of sound business planning and financing. By regularly monitoring this metric, you can proactively address potential cash flow issues and position your business for long-term success. 

For expert guidance on managing your finances or optimizing your financial strategy, try accounting software, like QuickBooks.