Debt Service Coverage Ratio (DSCR): What it is, examples and how to calculate it.
Simply put, a DSCR stands for Debt Service Coverage Ratio; a calculation lenders and other institutions use to assess your business credit.
Maths can be quite intimidating, but don’t be frightened! Ratios are purely an implication of your business’s performance and are used by lenders to assess the financial health of your business.
So maths is pretty important in a business scenario, but is your business avoiding it? Or perhaps you’re avoiding it to escape knowing your business’s full financial situation?
What we aim to do in this article is simplify the maths, make it more accessible for you and take you through some easy tips to better understand your business.
What is a Debt Service Coverage Ratio?
To make things easier, we can simplify the debt service coverage ratio term to DSCR. What the DSCR calculates is the ability of a business to repay their loan. Lenders want to be certain that your business can generate the cash flow and have the growth potential to pay them back.
How does it help lenders calculate eligible finance?
DSCR is a popular benchmark used by lenders in the measurement of an entity’s ability to produce enough cash to cover its debts. The higher the ratio, the easier it is to sustain a loan. This helps to focus on the future potential of a business’ ability to pay back a loan, rather than relying on a backwards-looking credit score of what’s happened in the past.
How to calculate your DSCR
You might be wondering how to go about calculating your own ratio. It’s relatively simple… Just take into account a few factors and you can determine what most lenders will look at before they will extend you a line of credit.
DSCR = Net Operating Income / Annual Debt Obligation
Net operating income (NOI) = Revenue from the last 12 months – operating costs.
Annual debt obligation (ADO) = Principal repayment + interest payments + lease payment + ATO (tax) debt.
Once you’ve calculated the ratio, the next step is to know what the number means.
Above 1 – The higher the better. Higher ratios indicate that a business has more cash as a buffer and is more likely to be able to pay back their loan.
Below 1 – Means that you don’t have the ability to pay your debts in full and makes it difficult for lenders to lend higher amounts to you. If your score is below one, read on to find out how you can increase your ratio.
Let’s use a retailer as an example. K&J Clothes are an online retailer specialising in selling outdoor activewear for men. To calculate K&J Clothes’ net operating income, they need to calculate their revenue, then minus their operating expenses.
Let’s assume this figure equates to $150,000 and their current annual debt obligation (ATO debt + lease payments + principal repayment + interest payment) is $200,000. When we divide their NOI by their ADO we produce a ratio score of 0.75. What this number indicates is an inability to pay back the loan. However, this number should only be used as an indicator and some lenders, such as Spotcap, consider many more variables when calculating loan eligibility.
How can you improve this ratio?
There are various ways to improve a company’s DSCR score. Although this may take time and some tough cost-cutting measures, it allows your business to perform better and have improved financial control.
There are a number of ways to increase your ratio score:
- Manage your costs more effectively – whether it be using uber or even public transport rather than a taxi, or perhaps as a rule of thumb, do not purchase assets that will not produce a return in the future.
- Improve profit margins – By charging more for your product or using cheaper source materials to produce your product, you can earn greater profits, improving net operating income.
- Refinance expensive finance with cheaper finance – This allows you to save on interest payments and reduce your annual debt obligation.
- Negotiate supplier costs – To create long-term relationships, suppliers are more than willing to renegotiate the circumstances to create longer lasting and synergetic affairs. You may also downsize operating area to reduce rent or simply move to a cheaper suburb or factory, or focus on increasing your offering to charge more to your clients.
- Advance payments – To reduce your annual debt obligation, what some companies will do is pay in advance on any outstanding loans and by doing so, will reduce their annual debt obligation. This makes your ADO lower, increasing the score of your DSCR. This is probably the simplest way to increase your DSCR score effectively and in a way that will quickly affect positive change.
- Negotiate trade payment terms with suppliers – By negotiating longer payment terms with suppliers, it allows for some leeway for businesses to smooth over cash flow and minimise the working capital currently required to operate.
Keep an eye on your finance
In order for businesses to be on top of their finances, it is necessary to be across a range of financial calculations to keep their businesses grounded and afloat. Simple calculations such as DSCR or spreadsheets such as a cash flow statement and profit and loss statement can at least give you some insight into the future, or help you realise the prospects of your business.
A basic understanding of financial systems is needed to have a firm grasp on what is going on in your business. The DSCR should be used by businesses that are looking to borrow money to grow and can be used to maximise the amount borrowed, thus being able to leverage this amount to accelerate growth.
If you want to know how much you could borrow, alternative lenders like Spotcap can advise – just ensure it’s obligation-free, so you’re not tied into any commitments once the health of your business is assessed.
Getting the finance you need could mean the difference between business growth and only just getting by… with the right injection of funds, you’ll be flying in no time.
Originally published on Flying Solo.
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Originally published July 23 2018