December 12, 2024
Adam Hoeksema
You’re in the process of applying for an SBA loan, but then your lender mentions something called the Debt Service Coverage Ratio—DSCR for short. So, what does DSCR mean? And why does it matter so much?
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For entrepreneurs and small business owners, a loan can be the key to growth—expanding your operations, upgrading equipment, or creating a space that draws in customers. SBA loans often provide the support needed to make those goals a reality. But getting approved isn’t just about having a great idea. You need to show that your business is a dependable investment, and understanding your financial metrics is essential
You may have heard the basics before—gross profit, net income, cash flow— but there’s one metric that can make or break your loan approval: the Debt Service Coverage Ratio, or DSCR. In this article, we’ll break down what DSCR is, how it’s calculated, and why it matters to your loan approval.
What is Debt Service Coverage Ratio (DSCR)
In simple terms, Debt Service Coverage Ratio (DSCR) is a measure whether a business or individual is making enough money to comfortably cover its debt payments. It’s calculated by taking the net operating income (think of it as the profit the business makes before paying interest and taxes) and dividing it by the total debt service (basically, the amount needed to cover loan payments, both principal and interest).
Most of the time, DSCR is measured on an annual basis. Lenders like to look at a full year of income and debt payments to see if a business’s cash flow is consistently strong enough to handle its financial obligations.
Are you wondering how net operating income is different from net income? Net operating income is the revenue left after all the day-to-day operating expenses like rent, wages, and utilities are taken out. But it doesn’t include interest and tax expenses. Net income, on the other hand, is what’s left after those additional expenses—interest and taxes—are subtracted too. So, net operating income is higher than net income because it hasn’t been hit with those extra costs yet.
How DCSR is calculated
The formula for the Debt Service Coverage Ratio (DSCR) is:
Where:
- Net Operating Income (NOI) is the income generated by the business after operating expenses are deducted, but before taxes and interest.
- Total Debt Service is the total amount of debt payments (both principal and interest) due within a given period, usually one year.
Let’s take an example. If a company has $100,000 in net operating income and needs $80,000 to cover its loan payments, then the DSCR would be 1.25. That means for every dollar of debt, there’s $1.25 in income to cover it. A ratio above 1.0 means a company is generating more income than it needs to pay its debt, which makes lenders happy.
Why It Matters for Your Loan Approval
Most SBA lenders want to see a DSCR of at least 1.25 to 1. A lower DSCR translates to higher risk, which means you might get offered a smaller loan or, worse, no loan at all. Make sure your business is running efficiently—boost that income where you can, trim those unnecessary expenses, and know your numbers inside and out before stepping into that lender’s office. A strong DSCR doesn’t just get you a loan but it’s a sign of your business’s financial health. So, when you’re prepping for that SBA loan, take a close look at your numbers.
How Lenders Assess DSCR
Lenders typically start by digging into historical financials. They’ll pull out income statements, cash flow records, and balance sheets from the last couple of years. The goal is to get a read on the Net Operating Income (NOI)—essentially, the money a business earns after paying for the essentials, but before dealing with the big stuff like taxes and interest on debt. If a business has a habit of performing consistently or even growing, lenders take that as a good sign. Stability is key.
Let’s break down with another example. Over the past three years, your business’ financials look like this:
Year 1: Net Operating Income (NOI) of $200,000
Year 2: NOI of $215,000
Year 3: NOI of $230,000
Now you want a loan with annual debt payments of $90,000. Time to put that DSCR formula to work:
DSCR = Net Operating Income / Total Debt Service
For Year 3, that’d be:
DSCR = $230,000 / $90,000 ≈ 2.56
This means that for every dollar of debt payment, your business generates $2.56. The trend over three years shows consistent growth. The history tells the lender that the company has been making smart decisions and knows how to manage its finances.
How to Improve Your DSCR
Step 1: Grow Your Revenue. Revenue is king. If you want to boost your DSCR, one of the easiest and most effective ways is to bring in more money. This is not an easy matter, but you can start exploring ways to elevate your revenue—whether by expanding the business, pursuing partnerships, or adding in-demand products.
Step 2: Keep Expenses Under Control. Growing revenue is great, but keeping an eye on your spending is just as important. It's not about cutting corners or being overly frugal; it's about making strategic decisions. A simple switch to a high-quality, budget-friendly option could save you thousands a month. Or, you negotiate better rates with your suppliers or rethink how you schedule your staff during off-peak hours.
These small tweaks can add up in a big way, leaving you with more net operating income. And the higher your net income, the more comfortably you can handle debt payments, making your DSCR shine.
Creating Financial Projections to Support Your Loan Application
A good financial projection model helps you organize everything you’ve gathered and show what the next few years could look like. It takes all that historical data and your thoughtful estimates and turns them into a forward-looking statement that tells your business’s story in numbers. The model should clearly show how your revenue and expenses will flow over the next few years, and most importantly, it should calculate your DSCR each year. And when those projections point to a solid DSCR, you’ve got what it takes to steer your business where it needs to go, and that’s how you turn a loan application into an approved loan.
DSCR is crucial for your SBA loan approval—it’s what convinces lenders you’re ready for it. Building a solid set of financial projections makes that case even stronger. Instead of starting from scratch, you can build on something that already has a framework. Tools like ProjectionHub’s CPA-prepared DIY projection templates provide a structured approach to creating accurate and professional financial projections.
Explore those templates, simplify the process, and don’t hesitate to consult a professional when you need it. If you need additional support, ProjectionHub also offers a template fill-out service where we build the projections for you. Our team at support@projectionhub.com is ready to get you on the path to securing the financing your business deserves.
