This is the fourth post in a series of articles about financial ratios.
In evaluating any borrower for a loan or lease request, one of the financial ratios that lenders run is a Debt Service Coverage Ratio (DSCR or sometimes DSC) to determine if the loan can be repaid. Ideally, the company will have sufficient profits to service the debt completely – with extra left over.
How Do You Calculate the DSCR Financial Ratio
To calculate the DSC on a proposed loan the formula is as follows:
Note that the top of the formula states “Annual Net Profit”. Once you add back the amortization/depreciation and interest, this is the income or cash flows that are left over after all of the operating expenses have been paid. This is often called earnings before interest, taxes depreciation and amortization – or EBITDA.
For “Existing Interest Expense”, make sure to include the interest of any debt that is being refinanced by this loan. Otherwise, just include the interest expense for any other loans you may have. Non-cash or discretionary items should include things like management bonuses.
On the bottom half of the financial ratio, the principal payments and interest payments are those of the new debt you are looking to take on.
The DSCR is also sometimes calculates without adding back in amortization/depreciation, interest expense or non-cash items. This means you are taking your net profit and dividing it by the loan payment and leases.
Neither method is right or wrong but you get two different numbers, leading to disagreements with or at the bank. You’ll often find that the person from the bank you’re dealing directly with will calculate it in the way that is most likely to get the loan approved, while the analyst or underwriter will calculate it using the method that provides the most protection for the bank.
As a quick example, let’s say that a company has net profit of $50,000 a year. Amortization and depreciation is about $2,000 a year, they are paying $500 a year in interest on an existing loan and they give themselves a $5,000 bonus at the end of each year. The company is looking at a new loan that will cost them $40,000 per year (both principal and interest payments). Their debt service coverage ratio would be 1.4375.
What Your Do With the DSCR
Most lenders have a minimum debt service coverage ratio they require. The SBA for instance stipulates that borrowers must be able to repay the debt 1.1 times. In other words, there is a 10% cushion left in case profits decline.
In boom times lenders often accept lower debt service coverage than they do during a recession. In fact, some complain that when banks did this, it deepened the current recession as there was not sufficient coverage to allow for declines in profits and personal income for borrowers.
I have personally done loans with a DSC of 1.1 and had them perform without a hiccup. However, more often I and my colleagues looked for DSC of 1.25 or greater. The greater the coverage ratio the easier the loan was to get approved and the lower the risk rating the bank assigned the loan. That often translates into lower rates.
Some banks have stricter DSC ratios for certain industries like restaurants or start-up businesses. The higher the DSC, the greater the comfort on the part of the owner that he or she can afford the loan even if business drops off.
Some DSCR Gotchas
You have to love a financial ratio.
From time to time items like excess owner compensation may be added to net profit if owner compensation is far above what the owner or owners need to live on. For that reason, sometimes two separate banks may come up with slightly different DSC ratios depending on what each feels confident they can add back to net profit.
Many times there may be several legal entities under the same ownership, such as an auto dealer who has the sales and repair organization as one company, the building held by another, and an investment property held by an organization separate from both the others. In these cases the bank may want to do a global cash flow analysis. They add the DSC of all entities together to come up with a global DSC ratio.
This is helpful as it allows the bank to enact covenants that limit the ability of the owner to shift income from one company to another to avoid making loan payments. It also gives a better picture as to the overall health of the owners business’ cash flow and profitability.
Banks often place covenants in their loan documents that stipulate the business maintain a minimum DSC for the life of the loan. The annual financials of the business are analyzed to determine whether the borrower is in or out of compliance with the DSC covenant.
Best Practices for Getting a Loan
When a loan request is being analyzed by a lender, the first thing they do is look at each financial ratio. It is preferable to have the business financials demonstrate the ability to repay the debt at, or above, the minimum DSC ratio for the prior three years. The ability to do so assures the lender that the business is stable enough in its profitability to repay the debt without issue going forward. When a company could have repaid the debt over the last three years at the required DSC ratio, we say the company “historically cash flows”.
Some companies are still creditworthy when they do not have sufficient historic cash flow. Perhaps they are adding a new product line that increases sales significantly in the future, or they are having their breakout year. Lenders will still want to lend to these companies. But they will try to mitigate the risk exposed by a lack of historical cash flow somehow – often by use of higher DSC requirements based on current and future financials to approve the loan. Or they may require an SBA guaranty of the loan, additional collateral, use a global cash flow, or projections of future financials for several years to address the issue. Many use a combination as the ”more the merrier” principle prevails in shoring up cash flow.
Business owners should monitor their own DSC regularly, at least quarterly to ensure they are producing sufficient profits to maintain their covenants and to avoid any future default. Doing so will also help guide them in allocating resources for future projects and expansion. What if spending capital on a new piece of equipment, for instance, will result in sufficiently lower DSC for the year? Perhaps that purchase can be put on hold.
So now you have the ability to analyze your ability to repay a loan. While this is only one type of ratio used in approving a loan request, a loan that does not have a DSC of at least 1.1 is unlikely to be approved, nor should it be.
Check back next week for another exciting installment on my ongoing series on financial ratios. Understanding them is key to understanding your success and failures in running your company.
Prior Articles in this Series:
Turn Baby Turn – Why Inventory Turns Matter – The Inventory Turn Ratio
Debt to Net Worth – The Pros and Cons of Leverage
The Current Ratio – What Does Your Financial Statement Actually Say??
Wesley John
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