If you are applying to get commercial loans, lenders will use qualitative and quantitative metrics to determine your eligibility. In all these metrics, DSCR is one of the most significant since it gets directly to the question every lender attempts to find out: Can you pay the loan back in full and on time? Your company's DSCR assists the lender in determining the extent to which your company can qualify for the small business loan, how big the loan they will accept, and what conditions you'll be getting for the loan.
Calculating DSCR isn't as easy as putting numbers into an equation. It's important to understand how to interpret your results, what is involved in this calculation and what lenders will be checking DSCR. Learn more about all this, check how to increase your DSCR and learn whether you don't have a high enough ratio to be eligible for the most suitable financing.
Did You Know?
A “one” or above debt service coverage ratio displays that an organisation produces sufficient management income to collect yearly interest and debt payments. In DSCR, keep in mind that an ideal DSCR ratio is 2 or above, and a high ratio will let you know the organisation is capable of taking more debt if necessary.
What is the DSCR Ratio Formula?
Let’s start with understanding DSCR's meaning. The lenders can use slightly different methods of the calculation of DSCR. In the early stages of submitting your loan process, inquire with your lender if they have a check on DSCR and what they do to determine the ratio. If you're looking to calculate this figure by yourself, this is the most popular formula to calculate your debt coverage ratio (DSCR):
DSCR = Annual Net Operating Income/Annual Debt Payments
The DSCR formula should include any existing debt and that loan application. One of the most common mistakes entrepreneurs make when calculating the debt coverage ratio of their business is that they are only taking into account the loan being sought.
The lender must consider how they can determine how all your business debts (plus your other existing debts) affect your ability to repay the loan.
Below are debt types that you must include in the formula for your DSCR formula:
- Online loans and bank loans
- Short-term loans
- Leasing
- Financing invoices
- Business credit cards and Business lines of credit
Also Read: Simple Explanation of Solvency Ratio and its Types
Net Operating Income Formula
Net Operating Income is an important part of how to calculate DSCR. It is also known as NOI, a formula that investors in real estate use to calculate a specific investment's profitability. NOI determines the income and the profitability of real estate investment property by deducting the vital operating costs.
The net operating income calculation is to deduct all operating costs from the revenues gained by a given property. The formula is:
Real estate revenue - Operating expenses = NOI (Net operating income)
Debt Payments Formula
Principal Repayment plus Lease Payments plus Interest Payments = Debt Payment
The interest rate can be calculated by dividing the per year interest rate by 12. For example, if your annual interest rate is 18%, your monthly interest rate will be 1.5% of the total principal amount (18/12).
What is a Good DSCR Ratio?
When you look at your commercial real estate debt to equity ratio, you may be wondering, "What Is an ideal DSCR ratio?" The answer depends on your circumstances, but a DSCR greater than one indicates that you have enough cash flow to make your debt payments.
While lenders have their own minimum requirements, most prefer a ratio of 1.2 to 1.4. A good ratio is 2.0, but some lenders may allow borrowers to have a lower DSCR if they have other assets to pledge as collateral.
The debt service coverage ratio (DSCR) is a financial indicator that can help you decide if an investment is worth taking. This ratio measures the amount of money available to pay back debts in one year, and it takes into account current net operating income and debt expenses.
A high DSCR ratio indicates that you have enough cash flow to make the loan payments at least once a year. For borrowers with a high DSCR, this is a sign that you have extra money and good money-saving habits.
Using DSCR can help you determine whether or not a property offers a good return on investment. DSCR is a percentage that considers a property's estimated monthly income and expenses.
If the DSCR is low, it will ultimately cost you more money in the long run. However, it is important to use a DSCR to evaluate a property's value and make smart decisions. Also, you can read about what is capital expenditure to get more ideas about improving your business profit.
How Can I Increase My DSCR Ratio?
If you are thinking about taking out a loan to renovate or buy a property, you will probably wonder how to increase DSCR. A lender will want to know how your current debt will affect the ability of your business to pay back the loan. The lender will look at both of these factors to calculate the ratio. So, increasing DSCR becomes vital. Here are the methods to do the same:
1. Increasing Its Operating Net Income
Net operating income (NOI) is an important metric to measure how well your business is doing financially. Net operating income is revenue minus cost of operations, or COE, excluding taxes and interest payments. When the DSCR is low, your business will likely be overextended, but you'll gain more cash if you increase your net operating income. And if you want to increase your EBITDA, you can lower your operating expenses.
2. Decreasing Expenses
Decreasing your monthly debt payments is another effective way to increase DSCR. Refinancing existing loans will lower the interest costs that you pay each year. Then, you can pay off existing debts with the extra cash. This method is beneficial for many businesses.
It helps improve the overall DSCR and increases the chances of getting a loan or infusion of capital. Further, increasing your net operating income will help you cover your expenses. If you're looking for additional cash flow, you can hire an extra salesperson to increase revenue.
3. Paying off Existing Debt
To increase your DSCR, you will need to improve your business's debt service coverage ratio. The DSCR can be calculated by dividing EBITDA by the minimum debt service requirement, and you need a ratio of at least 1.0 or more.
A DSCR of less than 1.0 indicates that your business uses its cash resources unwisely and will need to borrow money to cover its obligations. From the DSCR formula only, it's easy to figure out how paying off the existing debts increases the DSCR ratio and has a direct impact!
4. Reducing the Amount of the Loan Request
A high DSCR is beneficial for both the lender and the business applying for the loan. By calculating the DSCR ratio, the business owner can determine if its loan request is reasonable. If so, the business can devise ways to improve the ratio and increase its chances of loan approval.
If you're unable to pay off your existing debts or decrease expenses for attaining a good DSCR ratio, then the other way of attaining your target is to reduce the loan request amount.
Also Read: Accounting Ratios – Meaning, Types, Formulas
DSCR Example
The DSCR Example provides an overview of calculating a debt service coverage ratio (DSCR). This measure is more detailed than the EBITDA to interest payments ratio, and it divides EBIT by the amount of principal and interest payments and net operating profit. A ratio below one is considered a firm that lacks the adequate income to meet its debt obligations, and a ratio above one is regarded as an excellent DSCR.
To calculate the DSCR, divide the net operating income (NOI) by the total debt service (DS). The formula is Net Operating Income/Total Debt Service (NOI/TOD) in Excel. The first cell of the sheet should be titled "Net Operating Income", and the second cell should have the title "Debt Service."
For example, let's consider Net Operating Income to be ₹1,30,000/year while the total debt service equals ₹1,00,000/year. In this example, the DSCR will be ₹1,30,000 / ₹1,00,000, and the answer will be 1.3. Seeing an "x" after the DSCR ratio is common. In our example, it could be indicated as "1.30x." This shows that Net Operating Income covers debt service 1.3 times.
Conclusion
The Debt Service coverage Rate can be an extremely useful measure of a company's overall financial health and, in particular, the capacity to manage its debts. This ratio can assist investors and lenders in determining whether it's appropriate for a company to accept additional debt financing.
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