Using Debt Service Coverage Ratio to Assess Risks of New Business Loans
The debt service coverage ratio (DSCR) is an important financial metric that lenders use to evaluate the ability of a business to repay a loan. Specifically, the DSCR looks at how much cash flow a business generates relative to its debt obligations.
When considering a new business loan, lenders will carefully analyze the DSCR to determine if the additional debt from the loan is likely to overburden the business. A DSCR that is too low signals high risk that the business may default on the new loan. On the other hand, a healthy DSCR indicates the business generates sufficient cash flow to service the additional debt.
-What is the Debt Service Coverage Ratio?
The debt service coverage ratio measures a company’s ability to cover its current debt payments. It is calculated by dividing a company’s net operating income by its total debt obligations due in a year.
Formula:
DSCR = Net Operating Income / Total Debt Obligations Per Year
For example, if a company has $1 million in net operating income and $500,000 in total debt payments due in the next year, its DSCR would be:
DSCR = $1,000,000 / $500,000 = 2.0
A DSCR of 1.0 means the company’s net operating income equals its total debt payments. A ratio above 1.0 signals the company generates enough cash flow to cover annual debt payments.
DSCR Thresholds for Loan Approval
Lenders have different DSCR requirements to approve loans, depending on factors like industry, market conditions, and type of loan. Some general DSCR thresholds are:
- DSCR > 1.20 – Most lenders prefer to see a DSCR of at least 1.20 or higher. This allows a 20% cushion in case revenues decline.
- DSCR 1.00 – 1.20 – Loans may still be approved but terms won’t be as favorable.
- DSCR < 1.00 – High risk of default. Most lenders will not approve additional loans if DSCR is below 1.0.
For some high risk loans like startup business loans, lenders may approve if DSCR is above 0.80. But interest rates and fees will be much higher to account for risk.
Using DSCR to Assess New Loan Risks
When a business applies for a new loan, lenders go through a rigorous underwriting process examining many aspects of risk. The DSCR analysis focuses specifically on whether the additional debt load appears manageable given projected cash flows.
Lenders will evaluate both current and projected DSCRs under different scenarios:
Current DSCR
- Assesses repayment ability under latest 12 months financials
- Helps benchmark current cash flow coverage
Projected DSCR With New Loan
- Determines if business can support additional debt
- Stress tests best/worst case scenarios like revenue declines
DSCR Break-Even Analysis
- Models how much revenues can drop before DSCR falls below 1.0
- Highlights risks to monitor if loan is approved
Lenders may approve loan requests if current and projected DSCRs meet minimum thresholds. However, the breakeven and risk analysis often influences loan terms like duration, interest rates, fees, and covenants.
For example, a company with a strong current DSCR but only modest cushion in worst case projections may get approved. However, loan terms may be shorter than requested. This reduces risk over long durations where projections are less reliable.
Tips for Improving DSCR to Qualify for Loans
For business owners with marginal or substandard DSCRs, improving this ratio can significantly increase lending options and terms. Some tips include:
Boost Net Operating Income
- Increase sales revenues if possible
- Tighten expenses without impacting operations
- Seek profit rich products/services/customers
Repay Existing Debt
- Pay down debt balances
- Renegotiate terms for better cash flow
Raise External Equity
- Issue stock if incorporated
- Seek private investors
- Crowdfunding
Even modest improvements in net income or debt reduction can greatly help in strengthening DSCR. A detailed cash flow analysis is very useful for simulating how contemplated changes impact this key ratio.
Conclusion
The debt service coverage ratio is a vital indicator lenders rely on to gauge risks when underwriting new business loans. A DSCR above 1.20 signals sufficient cash flow coverage for debt obligations. As the ratio approaches or drops below 1.0, risks of financial distress and default rise quickly.
Business owners seeking new financing should proactively manage their DSCR. Improving net income and paying down existing debts are effective ways to strengthen the ratio. This opens up far more lending options with better terms to fund growth plans. A reliable DSCR demonstrates the business can support additional sensible debt loads despite future volatility or negative shocks.
Resources
Articles on DSCR