This term is not nearly as well understood as it should be, and it is vital for anyone who runs a supply or manufacturing business to understand. Let’s take a look at the definition, along with an example or two of its impact on day-to-day business.
Debt Service Coverage Ratio (DSCR) (n.)
- Finance and Account: A method of evaluating a business or entity’s operating cash flow available to pay any debts outstanding within a given time period.
- Government Finance: a government’s income from export earnings needed to cover interest payments on debts owed externally
- Personal Finance: a ratio used by lenders to approve or deny income property loans
A desirable DSCR is 1 or higher, as it means that the entity in question (business venture, government, or individual) can cover 100 percent of their debt obligations every year. The ratio is calculated by dividing net operating income by total debt service, or the interest, principal, lease, or sinking-fund payments due over the course of the year. Net operating income is defined as the amount of money coming in every year after all operational expenses (utilities, supplies, payroll, etc.) for a business have been paid. In other words, all earned income before debt, interest payments, and taxes.
When determining whether or not to agree to a loan, most lenders and financing entities will first look at a business’ DSCR to ascertain if they have the necessary operating income to pay regularly on their debts. In fact, some lenders look for rations higher than 1 since businesses that are too close to that number in terms of cash flow may already by cutting things close in terms of what they can handle. Businesses with a ratio close to 1 or just above it could suffer a temporary interruption of cash flow that could spell future default on a debt.
In short, DSCR is the primary indicator to lenders and suppliers who extend short term credit of a business entity’s ability to pay their debt obligations each year. If a business has a DSCR of .90, their creditworthiness is considered less than ideal since they can only cover 90% of their debt obligations each year. However, some lenders still agree to loans and short term credit for entities with DSCRs of less than 1, as they may have significant secondary income (rental income from properties, other divisions within the company, etc.) that would cover their debt obligations should their operating cash flow fall short.
For your business, a good DSCR is essential to attracting investors and maintaining creditworthiness. Making certain you maintain a sufficient DSCR helps protect you, your suppliers, and your business as a whole.
