How Does Debt Serviceability Affect Your Small Business
A debt-service coverage ratio (DSCR) can make all the difference for a business owner when seeking financing. Although there can be many components of the debt-service coverage ratio, in simplest terms, it is a measure of cash flow available to pay current debt obligations.
To calculate the DSCR, you divide your business’s net operating income by its total debt service. However, when you are accounting for net operating income, there are a few less-obvious obligations to remember as you consider all obligations due within a one-year period. Net operating income is a company’s revenue minus its operating expenses, not including taxes and interest payments. It is often considered equivalent of earnings before interest and tax (EBIT).
How It Works
For example, let’s consider Jim’s Auto Repair. Due to increasing customer demands, the owner, Jim, is looking to hire more staff and upgrade equipment. Before Jim makes any sudden decisions, he realized he needs to take a look at his finances.
Per his accountant, Jim has:
- A net operating income of $200,000.
- Debt obligations of $80,000.
- By dividing $200,000 by $80,000, his accountant determines Jim’s Auto Repair has a DSCR of 2.50.
This is great news for Jim and his business because most lenders favor businesses that have a DSCR of 1.25 or above. When they look at this number, it tells them that Jim’s Auto Repair can cover all of its debt obligations. A DSCR of less than 1.0 means negative cash flow, which means the borrower will not be able to cover all of his current debt obligations.
Sadly, this is not the case for Steve’s Auto Center, a competitor with a DSCR of .95, which means the business can only cover about 95% of its current debt payments.
Implications and Solutions
Unfortunately, a business’s DSCR eligibility can make all the difference if the business is approved for funding. It also helps dictate the funding amount and terms for which the business is eligible.
There are solutions for businesses that fall short of having a strong DSCR, like Steve’s Auto Center. Businesses can boost this number by increasing their revenues and/or decreasing their business expenses and/or lowering their debts. Most lenders will look favorably on a business that is able to combine all three steps. If a business is able to show an increase in its DSCR it will be much easier to secure financing.
When the time comes to seek additional funding, be sure to stay one step ahead by calculating this ratio for yourself so you can more accurately know what to expect when dealing with lenders. It will also help your business stay clear of any possible bumps in the road and ensure a smooth trajectory down the road!