One of the most obvious reasons commercial loans are denied is because an applicant does not meet lenders’ minimum debt service coverage ratio (DSCR) requirements. A company’s debt service coverage ratio (DSCR) refers to its capacity to cover loan payments out of their net operating revenue. It is one of the chief factors used to determine the fundability for a commercial loan application.
Why DSCR is important
The debt service coverage ratio is one of the many ratios assessed by lenders when considering a loan application, and for that reason, it is important for anyone in need of a business loan to understand. The biggest consideration for any lender is whether the applicant will be able to repay the loan or not. Banks and other financial institutions do not want lose their money, so they have to be reassured that the applicant has generated, and will continue generating, enough income to repay the loan together with the agreed interest.
In fact, these lenders additionally want to see that the business has some additional surplus cash flow beyond the minimum required to repay the loan. If a business is barely generating enough returns to repay the loan, it may not be doing well enough to deserve being approved for a loan.
Before approaching a financial institution for a loan, you ought to calculate your DSCR first and improve it if necessary. The DSCR of your entity for the next two years should be included in the business plan you present to potential lenders. Additionally, if your business is still growing or you are applying for a loan to buy an existing entity, the prospective lender would want to see DSCRs for the preceding three years. They will therefore not be relying on projections only, but also on evidence that the business is really thriving.
Understanding how a lender calculates the DSCR can help one know how to do the workings themselves prior to submitting an application. Below is an example of a lender’s calculation of a commercial mortgage DSCR.
The DSCR of a company indicates that its revenue is enough to meet its intermittent debt service payments. Regarding this, a DSCR value of greater than 1 is preferable and correlates more solidly with a company’s capacity to settle its outstanding liabilities. On the other hand, a value of less than 1 translates that a company is not in the position to raise sufficient income to repay its debts.
Different lenders have different DSCR specifications, and depending on the requirements of any transaction, the entailed DSCR could be slightly higher or lower. On the whole, those lenders offering the lowest rates would loan an entity with a higher DSCR than lenders with higher rates. Generally, though not always, the higher the rate, the easier it is to obtain a loan. A reasonable assumption is that most national banks would want to see a minimum DSCR of 1.25/1.
How to calculate the DSCR
DSCR = Net Operating Income (NOI) / Debt Service Costs
Suppose ABC Enterprises generates net income worth $1 million in a certain quarter. For the same quarter, its payments on outstanding debts due is $900,000. What is ABC’s DSCR?
DSCR = 1,000,000 / 900, 000
In this example, ABC Enterprises made 11 percent more income than was needed to meet the quarter’s liability payments.
How to improve DSCR
First of all you need to settle your credit cards. Lenders (banks in this case) add a percentage of your total balance to your total debt service. The amount varies from bank to bank but can be around 3% of your total balance per month. For instance, if you have credit card debts amounting to $100,000, a bank would assume $3000 in monthly payments.
The most important year for the DSCR to most of the lenders out there is the final year that they have audited financial statements or tax returns. So in case you are on the verge of applying for a loan in 2015, you want your 2014 taxes to be included in your evaluation.
Make sure you review all expenses from previous years. In case you have one-time expenses that should not be repeated, notify your lender so that this money could possibly be added back to calculate your cash flow:
– banks like seeing positive long term cash flows when making loans
– hopefully, your business’s current income will surpass the previous year’s income.