So, you’re here with one very specific question to ask: “What is debt coverage ratio?” The answers to that question may differ, depending on whether you’re applying for yourself or a business. It may even be more important to ask yourself other questions entirely. Questions like “How does this ratio apply to me?” or “Why is it important?”
Applying for a business or personal loan can be a stressful experience. There’s a lot to decide on, and a lot of planning to do if you want to make sure you can pay it off responsibility. And all of that’s assuming you actually get the loan, which many people don’t. Your debt coverage ratio has a direct impact on this, as one of the most leading indicators of your ability to pay your lender back.
But we’re getting ahead of ourselves. Join us, today, as we break down the debt coverage ratio, what it means, and why it’s so important to your business.
What Is Debt Coverage Ratio?
The first thing you’ll need to know about the debt coverage ratio is that it is different depending on where it is being used. In businesses, the Debt Service Coverage Rate (DSCR), or debt coverage ratio, measures how much of your cash flow can be used to pay your debt. This ratio represents net operating profit in multiples however much debt needs to be paid off within one year. This, in turn, covers everything from interest and principal to lease payments and operating.
When applied to government financing, the DSCR refers to how many export earnings will be needed to meet certain benchmarks. These include the country’s annual interest and the principal payments on its external debts.
Finally, when applied to personal finance, the DSCR is a ratio that bank lenders will use to determine income asset loans for an individual. In each of these cases, the one commonality is that the ratio reflects your ability to your unique loan payments and debt given your own income.
- This ratio is a measurement of your cash flow and how it could be used to meet your debt expectations over the course of one year.
- The DSCR applies to different situations and can be used to analyze companies, unique projects, and borrowers.
- The minimum ratio required will differ depending on the macroeconomic conditions at play during your loan.
- In a growing economy, lenders will be more likely to overlook a low ratio. During an economic downturn, things may become more tightly reigned in.
How To Calculate The Ratio
The standard version of the debt coverage ratio formula looks like this:
Debt Coverage Ratio = Net Operating Income / Annual Debt Payments
Pretty simple. With this formula, we include a net operating income that is your overall income after expenditures. We do not, however, have to include taxes, depreciation, or interest payments (although we can if we wish). We arrive at a number that is this net income, divided by our annual debt payments, for a straightforward ratio of a business’s ability to pay its debt.
If you do not want to include your additional expenses, by the way, the following formula will be more appropriate:
Debt Coverage Ratio = (Net Operating Income – T) / Annual Debt Payments
In the above formula, “T” stands for “taxes, depreciation, amortization and interest payments”.
For the sake of clarity, we’ll specify that annual debt payments include any debt payments you have to pay for over the course of the current year. The amount being repaid includes both short-term and long-term debt, s well as any potential new loan payments. In essence, this is all the debt owed by your business, condensed into one number.
When using the above formulas to calculate your company’s debt coverage ratio, you’ll want to aim for a number greater than one. Anything less than one takes you into negative integers and means you’re not turning enough of a profit to pay your debt obligations for that year.
With a ratio greater than one, your remaining profit can reasonably cover the amount. If you were considering additional debt, it’s generally recommended for a company to hit a debt ratio of two or more. This isn’t good advice: financial lenders will often insist on a percentage in this range, as a sign of good faith that the debt will be well controlled. Which leads us, neatly, into our next section…
Why Your Ratio Is Important
The Debt Service Coverage Ratio (DSCR) is, as we’ve mentioned, a favorite took among financial lenders. It’s one of many financial ratios these institutions will use to evaluate you or your business for a loan.
This ratio stands out, however, because of the clarity with which it tells lenders whether you can pay interest of not. Because, never forget, your ability to pay consistently on your interest is what most lenders are most interested in. Nobody wants to chase a loanee around the country because they defaulted. They use formulas like this as a safety measure, finding confidence in your business’s ability to keep up payments.
Business loans rely on simple math, at the end of the day. If a lender sees that your income amounts to sporadic, uneven amounts of money coming in, that typically won’t be enough to qualify for a loan. The hope, always, is to find a lender who has enough minimum cash flow to repay the loan quickly, if situations change.
As a last note, keep in mind that taking out personal loans you can’t afford to pay off is also not recommended, making this formula even more important.
Are You Ready To Meet Your Debt Obligations?
Ultimately, the question, “What is debt coverage ratio?” can be answered pretty simply: the ratio of available income to your outstanding debt over one year. Using the formulas in today’s article, you can calculate your own viability for a loan well ahead of approaching a lender.
Are you a business owner looking to open up one or multiple lines of credit? Don’t go in blind: quantify your operating expenses, measure them against your loan payments, and be prepared, for better or worse.
For new businesses and old alike, make sure to check out some of our other blogs on getting set up to achieve all of your goals!
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