Your debt service coverage ratio is a calculation that shows the percentage of cash available to make loan payments after subtracting other expenses, and it is used by lenders to determine how risky your business is to lend to.
A ratio of 1 means that your business has the exact amount of capital required to make payments on a small business loan, while anything below 1 means you can’t afford the debt. The higher the number, the better your cash flow. A higher figure builds lender confidence, because it shows you can weather a revenue decline or increased expenses and still be able to repay the loan.
A ratio of 1 doesn’t leave any safety net in case sales decline or expenses increase, which is why most lenders require a debt service coverage ratio of between 1.25 and 1.5. If you don’t have good credit, they might require a ratio of 2 or more.
By calculating the ratio yourself, you can see where your business is currently at. Plus, you can use some of the tips below to help adjust the ratio in your favor or to show why you’re not a high-risk borrower when you apply for a business loan.
How to calculate your debt service coverage ratio
There are three steps to calculate your debt service coverage ratio:
- Add together these lines from your most recent annual income statement (some might be $0 for your business).
- Net income
- Interest expense
- Tax expense
- Depreciation expense
- Amortization expense
The sum of these numbers is EBITDA (earnings before interest, taxes, depreciation, and amortization). Divide this by 12 to get monthly EBITDA.
2. Figure out your monthly loan payments (principal and interest) with an online loan payment calculator or by asking your lender if you’re already working with one.
3. Divide monthly EBITDA by the monthly loan payment to get your debt service coverage ratio.
Ways to improve your debt service coverage ratio
To improve your debt service coverage ratio, you can either increase EBITDA or decrease the required monthly loan payments. Lowering monthly payments is something you can do immediately by shopping around for a lower interest rate or extending the repayment term of the loan.
If you can’t find a lower rate at first, you could offer your lender additional collateral to offset the lender’s risk in exchange for a lower interest rate.
A longer loan repayment period can lower monthly payments even if it comes with a higher interest rate. This frees up cash flow for the new loan, operating expenses, or growth strategies.
Improving EBITDA can take time since you have to increase revenue or lower your business’s expense structure. You can begin improving EBITDA revenue by:
- Finding new customers
- Entering new markets
- Raising prices
If you don’t have near-term options to grow sales, you can lower expenses by renegotiating costs with vendors or eliminating business travel and entertainment costs from your chart of accounts.
A final option and last resort to improve your debt service coverage ratio is to reduce your workforce. While this may not be ideal, it might be the best decision for a more efficient business, especially if you’re applying for equipment financing to modernize a factory with new machines, thus requiring fewer workers anyway.
If you’re in the growth phase, your debt service coverage ratio may not be in great shape because of the current higher costs. This isn’t uncommon. In these situations, you may be able to leverage your proven track record as a business owner, along with paperwork showing your previous ratios, when applying for financing.
How to negotiate a different debt service coverage ratio requirement
You may be able to negotiate a different debt service coverage ratio requirement by offering additional collateral to the lender, thus lowering their risk on the loan.
Showing the lender how your ratio has improved over time can also help the lender feel more comfortable, as it shows that you’ve managed the business well in the past and will likely continue to do so. The same recommendation applies if you’re in the growth phase and your debt service coverage ratio isn’t as strong as it once was. Showing proof of previous performance can build lender confidence.
Use your last 3 or 4 annual income statements and show how your debt service coverage ratio has grown each year, or what it was prior to expanding your business. Now combine this with sales forecasts to show the lender how the loan will help you increase revenue and improve your ratio in the future.
Don’t worry if your debt service coverage ratio isn’t perfect. While it’s one of a few debt ratios that matter to small business lenders, there are steps you can take to improve it, including by growing sales or decreasing expenses. Additionally, you can negotiate for a lower ratio requirement by offering collateral or finding other ways to reduce a lender’s risk.
