What is debt-service coverage ratio (DSCR) and how does it work?

If you’re a small business owner seeking financing, you’ll want to know about certain financial metrics that lenders use to evaluate loan applications, especially debt-service coverage ratio (DSCR).

“We consider a number of factors when evaluating a small business’s financial strength, but DSCR is one of the most important metrics we look at,” said Annastacia Bushman, senior underwriter in Commerce Bank’s Small Business Banking division.

Learn what DSCR is, how it’s calculated, why lenders put so much weight in this metric, and what you can do if your DSCR is too low.

What is DSCR?

The debt-service coverage ratio is a metric that compares a business’s operating income with its total debt obligations. The higher your DSCR, the better.

“DSCR tells us whether your business is generating enough income to pay back your required loan payments year after year,” Bushman said. “It’s important because it shows us with some degree of certainty that, with all other things being constant, you’re going to be able to repay the debt you’re applying for.”

A high DSCR not only makes it easier for a small business to obtain financing, but it may also enable you to qualify for more favorable terms, such as longer repayment periods.

“If your income falls for any reason, or your debt increases for any reason — such as economic factors, or competition moving in down the street and pulling some of your customers away — that’s going to negatively impact your debt-service coverage,” Bushman said.

How debt-service coverage ratio is calculated.

The formula many commercial lenders use to calculate debt-service coverage ratio is as follows:

EBITDA (earnings before interest, taxes, depreciation, and amortization) ÷ total annual principal and interest payments.

Example of a debt-service coverage ratio calculation for a small business:

• EBITDA: $227,000
• Annual principal and interest payments: $170,000
• Debt-service coverage ratio: 1.3

This means the business is generating roughly 33% more income than it needs to cover its debt.

Commerce Bank’s Small Business Banking division typically calculates debt-service coverage ratio in three different ways, according to Bushman.

“One is based on your business cash flow, one is on your personal income, and then there’s a global view that combines both your business and personal debt obligations,” she said. “We do this because small businesses are often tied very closely to the personal finances of their owners.”

Minimum DSCR requirements: What lenders look for across different loan types.

The minimum required debt-service coverage ratio will vary, depending on what type of loan a small business is applying for. However, in most cases lenders are looking for a DSCR of no lower than 1.2.

“A common misconception among many new business owners is that a DSCR of 1.0 is enough, because it means you can cover 100% of your debt payments,” Bushman said. “But that doesn’t leave any room for unexpected changes or downturns, which is why lenders typically look for a number higher than 1.0, so businesses have that extra cushion.”

Certain types of loans, including unsecured loans and lines of credit, have higher debt-service coverage requirements (usually around 1.5) because the risks are higher. SBA loans, on the other hand, have lower minimum DSCR requirements (usually around 1.1) because they are partially guaranteed by the Small Business Administration.

“If your DSCR is below the required minimum, another option is to increase your down payment,” Bushman said. “This would automatically lower your loan amount, and would help you meet that cash flow requirement.”

Similarly, if you’re a relatively new business that’s applying for a line of credit and your DSCR is too low, you may be able to start out with a smaller line. “As your revenues increase and you get more of a customer base, we may look at increasing that line down the road,” Bushman said.

Beyond DSCR: What else lenders are looking at.

“Small business owners should also keep in mind that although DSCR is a large piece of the puzzle, we’re also looking at a lot of other different factors aside from that,” Bushman said.

When evaluating loan applications, some of the other factors that lenders consider include time in business, time in the industry, individual and business credit histories, industry metrics, balance sheet strength, and whether or not you have an existing relationship with the bank.

What you can do if your debt-service coverage ratio is low.

If your DSCR is below the minimum, developing a clear plan to improve it can help strengthen your position with lenders. In some cases, a temporary decline may be the result of unexpected events, such as rising tariffs, the loss of a key employee, or other unforeseen disruptions.

Lenders understand that small businesses can face challenges and often look for evidence that owners are actively managing through them. These steps can help:

• Add a guarantor. “If you have someone who has the ability to help you repay your debt, we can add that outside income, and that’s going to automatically raise your debt-service coverage,” Bushman said.
• Find ways to cut your expenses. You can help strengthen your financial position by pinpointing inefficiencies and uncovering funds that are tied up in overlooked areas. Consider pausing or scaling back optional items. Also, take a closer look at your inventory so you can eliminate slow-moving products, and outsource tasks that aren’t core to your business.
• Diversify your revenue streams. One way to address inconsistencies in cash flow is to reduce your dependence on one product, client or season. By developing multiple revenue streams — such as offering complementary products or targeting new customers — your business may be able to generate more consistent income to cover debt obligations.
• Talk to a relationship manager. “If your debt-service coverage is low and you’re having trouble figuring out where to start, reach out to your relationship manager,” Bushman said. “We want your business to be successful. After all, that’s how we stay in business, too.”