Editor’s Note: This is one of an eight-part series about key financial terms all small business owners should know.
Financial literacy is important for all business owners, but it’s absolutely critical for those who are considering raising money in the near future. Here’s everything you need to know about debt-service coverage ratio (DSCR), with an expert weighing in on why it matters.
What is debt-service coverage ratio?
Debt-service coverage ratio is a measure of a company’s ability to pay its debt based on available cash flow. It is calculated by dividing net operating income (noi) by total debt service.”Debt service” is a term that refers to all obligations due within one year. This includes short-term debt and the current portion of long-term debt on the company’s balance sheet.
Why is debt-service coverage ratio important?
Debt-service coverage ratio is important because it shows investors and lenders that you have positive cash flow. Having positive cash flow shows that you have made smart managing decisions in balancing your debt obligations and operating expenses. If you DSCR calulations show that you have a DSCR of less than one (1), that means your business has negative cash flow. A negative cash flow indicates, essentially, that you will need to borrow money to pay off existing debts.
How can debt service coverage ratio impact your ability to raise capital?
Though varying economic conditions and differences from industry to industry impact the minimum DSCR an investor or lender will look for, generally speaking, the higher your DSCR, the easier it will be to raise capital. If your DSCR is below one (1), raising or borrowing might prove incredibly difficult — or, at least, prohibitively expensive. Conversely, if you have a high DSCR — say, above 1.5 — you can use it as a bargaining chip. Knowing that your company may be considered an attractive investment gives you the power to seek out favorable terms from potential investors and lenders.
How can you improve your debt service coverage ratio?
To better your chances of getting a loan or other infusion of capital, you will need to increase your DSCR. Doing this may not be as difficult as you may think. One thing you can consider is looking into increasing your net operating income to cover expense. Another is decreasing your operating expenses. With both of these, you can use the additional cashflow to pay off existing debt. All three of these – increasing your net operating income, decreasing your operating expenses, and paying off some debt – help to improve youre DSCR.
When looking to increase your net operating income, think of some ways you can quickly and easily increase your revenue such as turning excess inventory into extra revenue, leveraging tactics your customers already trust to increase your sales, and making sure you are taking advantage of every lead or potential customer that comes your way.
Giving a boost to your revenue is only one way to increase your net operating incoming. Another quick and easy way to accomplish this is by decreasing your operating expenses. Believe it or not, there are a number of ways you can decrease operating expenses and free up some of your capital – from revisiting vendor relations and strategies, to splitting core and convenience ordering to improving your negotiation skills, you’re sure to find an area to cut expenses. You can also find ways to increase employee productivity, and improve processes.
Ask an expert about debt-service coverage ratios:
Vincenzo Villamena, managing partner of entrepreneur-focused CPA firm Global Expat Advisors, breaks down why debt-service coverage ratio is so important for entrepreneurs to track.
Why is debt-service-coverage ratio an important metric investors and lenders consider before funding a business?
Investors and lenders use the DSCR to see if you can make your monthly loan payments. It is also used to determine how much they can lend you safely on any economic condition. The DSCR makes you more likely to qualify for a loan and receive better terms for the loan, such as lower interest payments and higher borrowing amount.
What’s a solid DSCR business owners should strive to maintain while growing a business?
Generally speaking, a DSCR of 1.2 or better is considered good. Although, I have seen loans given to companies with 1.1 ratio. I’ve also seen when the economy or an industry is down, the banks requiring a ratio of 1.5 or better. So there is always a variance.
If an entrepreneur has a DSCR below 1, what explanation might he/she be able to offer to would-be investors and lenders to ease their concerns?
If the DSCR is below 1, there needs to be a good explanation to give to investors and lenders, such as a lot of R&D costs, hirings or a recent product launch in which the true revenues of the company do not reflect the YTD or LTM financials.
A key to success as a business owner is never being afraid to admit what you don’t know. Don’t know as many financial terms as you’d like to? No problem! Check out the other installments in this series covering The next installment of this series, where you will learn everything you wanted to know about turnover ratio, debt to income ratio, payables turnover ratio and current ratio