Applying for a small business loan is a lot of work. It takes time and effort to research options, compile paperwork, fill out forms, and do everything else that goes into each application—especially when it’s not totally clear how standards vary from lender to lender!
With so much involved and so much at stake, you don’t want to be blindly filling out multiple applications and hoping your guess work pays off—so it’s important to make sure you check the qualification standards of each lender before you fill out their loan application. By knowing what each individual lender is looking for, you can increase your chances of being approved.
When you’re doing your research, one of the main criteria you’ll see pop up time and time again is your debt-service coverage ratio. Not sure what that is, how to calculate it, or why lenders care about it so much? We’ll explain.
What is Your Debt-Service Coverage Ratio?
To put it simply, your debt-service coverage ratio (DSCR), also known as your debt coverage ratio, is the mathematical equation lenders use to verify how much cash you have on hand to apply towards paying off your debt. By figuring out your DSCR, lenders will be able to answer one very important question: Can you afford the loan?
The Importance of Your Debt-Service Coverage Ratio
Not only do lenders want to see that you can cover the costs of your loan, they also want to see that you have a little extra money saved up for a rainy day. Lenders expect this because they know—as most veteran business owners can also attest—that it’s not uncommon for unexpected costs to arise in the day-to-day process of running a business.
Say you own a pizza shop, for example, and your oven breaks. You can’t very well make pizzas without an oven, can you? Lenders want to see that if something like this scenario were to happen, you would enough money to purchase the new oven without defaulting on your loan payments in the process.
All lenders have a minimum DSCR requirement for approving small business loans. Generally speaking, the ratio needs to be 1.25 or higher for approval. However, when the economy is doing well, lenders may accept a slightly lower ratio.
The opposite is also true—if the economy is not doing so hot, you may be required to have a DSCR of 1.35 or even higher. But overall, the higher your ratio, the better chance you have at securing your loan—no matter what shape the economy is in.
In addition to helping you get approved for a loan, calculating your DSCR is also a great way for you to determine the financial health of your business. So before you go through the application process, you may want to calculate this ratio yourself, regardless of your app’s requirements.
Calculating Your Debt-Service Coverage Ratio
You can calculate your debt-service coverage ratio in a couple of different ways. The two most common ways are:
Annual Net Operating Income – Depreciation & Other Non-Cash Charges/ Interest + Current Maturities of Long-Term Debt
EBITA (Earnings Before Interest, Taxes, Depreciation & Amortization) / Interest + Current Maturities of Long-Term Debt
For example, if your company’s total annual net operating income is $20,000 and your loan will cost you a total of $16,000 for the year, your debt-service coverage ratio would be 1.25 ($20,000/$16,000).
If you currently have other debt, be sure to include that into your calculation as well. So, if you have an additional loan that costs you $4,000 annually, that would bring your total annual loan costs to $20,000 for the year, making your DSCR 1.0—not exactly a shoe-in for loan approval.
Monitoring Your Debt-Service Coverage Ratio
Since a lender will approve your loan application based upon your DSCR and your ability to repay said loan, you’ll want to make sure you maintain the same DSCR you had when you were approved. If your ratio drops after you’ve agreed to the terms of the loan, you could be violating your agreement. In order to maintain the ratio that’s been agreed upon in your loan contract, you should be sure to check your ratio at least quarterly.
To put yourself in a good position for getting approved for a loan, you want to Making sure that your debt-service coverage ratio is up to par with what lenders are expecting is key to getting your loan approved on the first try. Not only that, but in this case what’s good for the lender is good for your business as well. By calculating your loan’s cost and your DSCR, you’ll gain important information about your business and be able to make the wisest decision for your company’s long-term financial health.
Meredith Wood is the Editor-in-Chief at Fundera, an online marketplace for small business loans that matches business owners with the best funding providers for their business. Prior to Fundera, Meredith was the CCO at Funding Gates. Meredith is a resident Finance Advisor on American Express OPEN Forum and an avid business writer. Her advice consistently appears on such sites as Yahoo!, Fox Business, Amex OPEN, AllBusiness, and many more.