Monitoring the Health of Your Small Business: Calculating Your Debt Service Ratio

Understanding how to calculate your debt service ratio is crucial for the financial health of your small business. This ratio is a key indicator of whether your business can meet its debt obligations, which is especially important when you’re seeking a loan.

In this article, we’ll explain what the debt service ratio is, how to calculate it, and why it’s important for your business.

What Is the Debt Service Ratio?

The debt service ratio, also known as the debt service coverage ratio (DSCR), measures your business’s ability to cover its debt payments with its operating income.

It’s expressed as a ratio, and a number greater than 1 indicates that your business has more income than debt obligations, giving you a cushion to handle payments. A ratio below 1 suggests that your business might struggle to cover its debts.

How to Calculate the Debt Service Ratio

Calculating your debt service ratio involves a few key steps. Here’s how you do it:

Start with Net Income: Begin with your net income, which is the profit your business makes after all expenses are paid.
Add Back Non-Cash Expenses: Add back any non-cash expenses, such as taxes, interest expenses, depreciation, and amortization. This gives you your EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization), which is a proxy for your operating cash flow.
Total Your Debt Payments: Add up all the debt payments your business needs to make over the year. This includes loans, credit card debt, and any other debt obligations.
Divide EBITDA by Debt Payments: Finally, divide your EBITDA by your total debt payments. This number is your debt service coverage ratio.

For example, if your EBITDA is $200,000 and your total debt payments are $150,000, your debt service ratio is 1.33. This means you have 33% more income than needed to cover your debt payments.

Why Is the Debt Service Ratio Important?

The debt service ratio is important because it’s a key measure that lenders use to assess your ability to repay a loan. If you have a strong ratio, it shows that your business is financially healthy and capable of taking on more debt. A weak ratio, on the other hand, may prevent you from securing a loan or might require you to offer more collateral or agree to higher interest rates.

Here’s why monitoring your debt service ratio is crucial:

Gauge Financial Health: Ensure your business can comfortably meet its debt obligations.
Prepare for Loan Applications: Understand what lenders will look for when you apply for a loan.
Plan for Growth: Use the ratio to assess whether your business can afford to take on new debt for expansion.

How to Improve Your Debt Service Ratio

If your debt service ratio is lower than you’d like, there are several strategies you can use to improve it. The goal is to either increase your operating income or reduce your debt obligations. Here’s what you can do:

Increase Revenue: Focus on growing your sales to boost your net income.
Reduce Expenses: Cut unnecessary costs to improve your operating income.
Refinance Debt: Look for opportunities to refinance existing debt at lower interest rates to reduce your monthly payments.

Why Lenders Care About Your Debt Service Ratio

When you apply for a loan, lenders will closely examine your debt service ratio to determine whether you can repay the loan. They will add the debt you’re asking for to your existing debt and check if your earnings can cover it. A strong debt service ratio gives lenders confidence that your business is a low-risk investment.

From a lender’s perspective:

Assess Loan Repayment Ability: A good ratio shows that your business can handle additional debt.
Evaluate Financial Stability: Lenders use the ratio to judge how well you manage your finances.
Plan for the Future: Lenders want to know that your business has a plan to maintain or improve its debt service ratio over time.

Conclusion: Be Prepared When Seeking a Loan

Calculating and understanding your debt service ratio is essential for any small business owner, especially when planning to borrow money.

By knowing your ratio and how to improve it, you can approach lenders with confidence and demonstrate that your business is financially stable and capable of handling debt.

Whether you’re looking to expand or simply ensure your business’s financial health, monitoring your debt service ratio is key to your long-term success.