As a small business owner, there will be times when you need to prove your credit worthiness—especially when applying for a loan. But savvy business owners want to know the financial well-being of their business before that time comes.
That’s where the debt service coverage ratio (DSCR) comes in. This calculation helps assess the financial well-being of your business. It measures the state of your cash flow to determine if you have enough to pay back current debt obligations.
Similar to a rainy day fund, extra cash comes in handy when your business faces unexpected expenses down the road. That’s why a healthy cash-flow cushion increases your chances of qualifying for a loan. On the other hand, when cash is tight, you’re a bigger risk for lenders. The DSCR is a useful tool for determining if your business is prepared to pay back a loan—even when the unforeseeable happens. Here’s how it works:
DSCR = net operating income ÷ total debt service
For instance, if your net operating income is $40,000 and you’re applying for a loan with an annual debt service of $32,000, the DSCR is 1.25. While the minimum debt service coverage ratio requirement varies among lenders, it generally needs to be 1.25 or higher. A DSCR that is less than 1 represents a negative cash flow, which most lenders are less than thrilled to see.
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