A debt service coverage ratio tells you if income can cover debt payments. Owners of small businesses use it to determine whether their companies can afford to pay debts. 

If you don’t already know how to calculate debt service coverage ratio, there is good news: The calculation process is relatively straightforward.

What Is the Debt Service Coverage Ratio in Simple Terms?

A debt service coverage ratio (DSCR) is the ratio between operating income or cash flow and debt obligations. It reveals to both lenders and borrowers whether a business can pay off a loan.

Real estate investors often use DSCRs, too. A property’s DSCR tells you if it will make enough money to cover the mortgage.

What Is the Debt Service Coverage Ratio and How Do You Calculate It?

To calculate debt service coverage ratio, you need one of the following formulas:

• DSCR = net operating income / total debt service
• DSCR = earnings before interest, taxes, depreciation and amortization / total debt service

Net operating income (NOI) is revenue minus operating expenses. Earnings before interest, taxes, depreciation and amortization typically is referred to by the shorthand of “EBITDA.”

If you’re a business owner calculating DSCR, using EBITDA is more common than using NOI.

If you’re calculating DSCR for a piece of real estate, you would typically use NOI instead of EBITDA.

How Do You Calculate a Debt Service Ratio?

Imagine you have a business loan and pay $50,000 each year in principal and interest. You go online and find an EBITDA calculator and discover that your company’s EBITDA is $100,000.

Now, you need to divide your EBITDA by your total annual debt service. Dividing $100,000 by $50,000 gives you a DSCR of 2.

What Is a Good Debt Service Coverage Ratio?

Knowing how to calculate debt service coverage ratios is important, and so is understanding how to interpret the results. 

Many business lenders look for a DSCR of at least 1.25, although minimum requirements vary by lender and loan type. That means a business can cover debt obligations with a 25% cushion.

In the example above, a DSCR of 2 may be seen as an especially good sign. It means your net operating income is twice your debt obligations. This may indicate that covering debt payments shouldn’t be an issue.

Practical Example: Business Loans

Imagine you’re starting a business, and you need to borrow some money to launch it. Your company’s EBITDA is $180,000. The loan you’re applying for will require you to pay a total of $200,000 per year.

To get your DSCR, divide your EBITDA by total debt service ($200,000). That gives you a value of 0.9.

A lender may see a DSCR of 0.9 as a red flag. The lender may interpret the number as indicating that your company probably won’t have enough revenue to cover debt payments. 

Now, imagine you apply for a smaller loan instead. With this loan, you’ll pay $120,000 in interest and principal per year. Dividing $180,000 by $120,000 gives you a DSCR of 1.5. That’s above the industry standard of 1.25, so you may be more likely to get approved.

Practical Example: Real Estate

Now, imagine you’re thinking about buying a rental property. Each year, the property brings in $150,000 in revenue. Its operating expenses are $50,000. If you buy the property, the mortgage will cost you $120,000 per year. 

First, subtract expenses from revenue to get an NOI of $100,000. Next, divide the NOI by your debt service obligations ($120,000).

That gives you a DSCR of about 0.83. Because the number is less than one, the property likely won’t make enough money to cover the mortgage, so buying it may not be a great investment decision.

You pass on that property and find another. This one also brings in $150,000 in annual revenue. However, its operating expenses are just $25,000. That means this property has an NOI of $125,000.

If you take out a mortgage to buy this property, you would have to pay the lender $100,000 per year. Dividing your NOI by that amount gives you a DSCR of 1.25. That means the property should make enough money to pay the mortgage and still leave you with additional cash to spend. 

Wondering How to Calculate Debt Service Coverage Ratio?

If you own a small business or are someone considering investing in real estate, understanding how to calculate debt service coverage ratios is important. 

When you take the time to calculate an accurate DSCR, you can make a more informed decision about which steps to take next.

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