Understanding Business Risk and Debt Service Coverage Ratio
DSCR stands for Debt Service Coverage Ratio. It is used by lenders to understand the risk associated with lending to their borrowers.
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DSCR stands for Debt Service Coverage Ratio and is often a figure used by lenders to understand the risk associated with lending to their borrowers. If you’re able to calculate the DSCR for your business, you’ll be able to better understand the terms that some lenders offer you. To be clear, this is not a factor that all lenders will consider but many commercial and real estate lenders use this as a key part of determining the maximum loan amount that your business could be eligible for. Your DSCR can be calculated by taking your “net operating income” or how much cash flow you have annually (or monthly), and dividing it by your total “debt service” or how much you owe back annually (or monthly). A DSCR that is 1.0 or greater means that there is enough cash flow to cover the amount of money being borrowed. If the number is below 1.0, it means that the borrower would be borrowing more than they could afford based on their current business income. Knowing your own DSCR will be important when advocating for yourself and for your business. If you’re offered a loan with loan terms that put your DSCR below 1.0, you should consider whether this is a risk you’re willing to take on for your business and possibly for yourself.
Let’s break DSCR down so you can see how simple this really is by applying it to a real life, personal example. Ask yourself the following question: if you were going to make a purchase, how would you figure out whether or not you could afford it? When I asked myself this, I immediately thought of when I recently purchased a bed frame. Before deciding how much I could responsibly spend on the bed frame, I thought about my existing cash flow against my monthly expenses. I wanted to figure out what a reasonable monthly payment would be that wouldn’t hurt my cash flow, force me to put the expense on a credit card that would accrue interest, or make me feel pressure to sacrifice necessary day to day expenses. I calculated a personal version of a DSCR - rather than owing a lender something, I imagined myself as the lender and borrower, and calculated what I would be comfortable owing myself. After deducting my day to day expenses and bills from my average paycheck size, I was able to understand what would be left over for either unplanned expenses, savings, or in this case, my bed frame. From this number, I chose a price range that felt safe in my mind for an additional monthly expense, and looked for a bed frame that could keep me within that budget. The price that kept me within my budget was the price that kept my DSCR at a ratio of 1.0 or higher. Borrowing money for a business can be thought of in the same way. Again, to understand how much I could afford to spend on a bed frame, I took my monthly expenses and compared them to my monthly income. This gave me guidance on how to spend money that I have, rather than spending money that I didn’t have and prevented me from needing to take on unnecessary debt.
It’s important to reiterate that this is not the only factor that a lender will consider when assessing loan terms for business borrowers. There are also many other ways to make decisions about which loan terms you want to accept, and which ones you do not. DSCR is just another tool in your tool belt that will help you advocate for yourself as a business owner who is looking to borrow funding for their business.