Debt Service Coverage Ratio: How Lenders Size a Loan
Debt Service Coverage Ratio: How Lenders Size a Loan
A business with $410,000 of cash available for debt service and $90,000 of existing payments can support about $1.57 million of new 10-year debt at 9% under a 1.25 coverage requirement. If the lender rejects $60,000 of add-backs, that falls to about $1.25 million. The debt service coverage ratio is usually where the loan amount comes from, and every input to it is negotiable.
What you'll learn
The ratio that sizes the loan
The debt service coverage ratio, or DSCR, compares the cash a business generates with the payments it owes on its debt. A ratio of 1.25 means the business produces $1.25 of cash available for debt service for every $1.00 of principal and interest due. For term loans, equipment loans, commercial real estate and acquisition financing, it is often the single number that decides how much a lender will offer. Per our small business underwriting analysis, lenders look at much else, but DSCR is where the loan amount usually comes from.
Lenders commonly require 1.20 to 1.35, and SBA guidance has set a minimum of 1.15 for many 7(a) loans. The cushion exists because cash flow is uncertain: a business at exactly 1.00 has nothing left if revenue dips.
Cash available for debt service
The numerator is not net income. Lenders start from earnings and adjust toward the cash that can actually pay debt.
| Item | Amount |
|---|---|
| EBITDA: earnings before interest, taxes, depreciation and amortization | $420,000 |
| Add-backs: one-time and discretionary expenses the lender accepts | +$60,000 |
| Maintenance capital spending | −$40,000 |
| Cash taxes | −$30,000 |
| Cash available for debt service | $410,000 |
Add-backs are where most negotiations happen. A one-time legal settlement or an owner's personal expense run through the business can reasonably be added back. Recurring costs labeled “one-time” every year cannot. Per our bookkeeping analysis and owner compensation analysis, clean books and a market-rate owner salary make add-backs credible; mixed personal and business spending makes every add-back a question.
Sizing a loan, worked
The business above already pays $90,000 a year on existing debt and wants a new 10-year loan at 9%, which requires about $0.152 of annual payment per dollar borrowed.
| Step | Amount |
|---|---|
| Maximum total debt service at 1.25× ($410,000 ÷ 1.25) | $328,000 |
| Less existing debt service | −$90,000 |
| Available for new debt service | $238,000 |
| Maximum new loan | about $1,566,000 |
| Change | Maximum new loan |
|---|---|
| Lender rejects the $60,000 of add-backs | about $1,250,000 |
| Lender requires 1.35× instead of 1.25× | about $1,406,000 |
| SBA-style 1.15× minimum | about $1,753,000 |
Losing the add-backs cuts borrowing capacity by about $316,000, roughly five times their annual amount. Per our acquisition financing analysis, this is why seller add-backs are scrutinized so closely in business purchases: they convert directly into how much the buyer can borrow.
Global debt service coverage
For owner-guaranteed loans, lenders often also compute a global DSCR that combines the business and the owner. If the owner draws a $120,000 salary, spends $60,000 a year on living costs and pays $36,000 a year on personal debt, global cash flow is $410,000 plus the $60,000 the owner does not spend, $470,000, against $364,000 of combined debt service including the new loan.
The global ratio is about 1.29, close to the business-only 1.25. But an owner with a large personal mortgage or car payments can fail the global test while the business passes, which is one reason lenders ask for personal tax returns and credit reports. Per our personal guarantee analysis, the guarantee makes the owner's finances part of the loan.
Coverage gets you the loan amount; credit gets you the terms
DSCR sets how much a lender will offer, and your business credit file helps decide the rate and conditions. HL Hunt Business Credit Builder reports on-time payments to business credit bureaus every month, building the record that supports better pricing on the loan your cash flow can carry.
Coverage for property loans
For owner-occupied and investment real estate, the numerator is usually the property's net operating income: rent or market rent, less operating expenses, before debt service. The loan is then sized by whichever constraint binds first, coverage or loan-to-value.
| Property with $120,000 of net operating income, valued at $1,600,000 | Amount |
|---|---|
| Maximum annual debt service at 1.25× | $96,000 |
| Loan supported at 7% over 25 years | about $1,132,000 |
| Implied loan-to-value | about 71% |
If the lender's maximum loan-to-value is 75%, coverage is the binding limit here, not collateral. At higher interest rates the same income supports a smaller loan, which is why rising rates reduce borrowing capacity on property even when values hold. Per our rate transmission analysis, this is one of the most direct channels from policy rates to small business credit.
New businesses and acquisitions use projections. Without a track record, lenders size loans on projected cash flow, discounted for uncertainty, or on the seller's historical results for an acquisition. Per our cash flow forecasting analysis, a projection a lender can trace to evidence, such as signed contracts or historical seasonality, carries more weight than one built on growth assumptions alone.
Improving coverage before you apply
- Document add-backs with invoices and explanations before the lender asks.
- Separate personal spending from the business so profit is not understated.
- Refinance or pay off small expensive debts. Per our stacking analysis, short-term advances with daily payments consume coverage far out of proportion to their size.
- Lengthen the term requested. A longer amortization lowers annual debt service and raises the supportable loan, at the cost of more total interest.
- Present a full year of improved results rather than a projection, since many lenders weight trailing results heavily.
DSCR after closing
Many loans carry a DSCR covenant, tested annually or quarterly. Per our covenant analysis, falling below it can allow the lender to raise the rate, demand more collateral or call the loan. Per our revenue decline analysis, a business whose revenue drops 15% can lose far more than 15% of its coverage, because many costs are fixed, so it is worth modeling how close to the covenant a bad year would bring you before signing.
The limits of the ratio
DSCR is backward-looking and can mislead in both directions. A fast-growing business with thin trailing cash flow may be a better credit than its ratio suggests, and a business with one large customer may show strong coverage that would vanish if that customer left. It also ignores the balance sheet: two businesses with the same ratio, one with ample cash reserves and one with none, carry very different risk. Per our business value analysis, lenders combine DSCR with collateral, liquidity and the owner's track record, and per our capital structure analysis, the right amount of debt for the owner may be well below the maximum the ratio allows.
Frequently asked questions
Cash available for debt service divided by debt payments; lenders commonly require 1.20 to 1.35.
Divide cash flow by the required ratio, subtract existing payments and convert the remainder to a loan. In the example, about $1.57 million.
One-time or discretionary expenses added back to earnings. In the example, losing $60,000 of them cuts capacity by about $316,000.
A combined business-and-owner ratio that includes the guarantor's personal income and debts.
Key takeaways
- DSCR divides cash available for debt service by principal and interest due.
- Lenders commonly require 1.20 to 1.35; SBA guidance has set 1.15 for many 7(a) loans.
- Cash available starts from EBITDA, adds accepted add-backs and subtracts maintenance capital spending and taxes.
- In the example, a 1.25 requirement supports about $1.57 million of new debt.
- Rejecting $60,000 of add-backs cuts capacity by about $316,000.
- Global DSCR adds the owner's personal income and debts.
- DSCR covenants after closing can tighten terms if coverage falls.
References
- U.S. Small Business Administration. SOP 50 10: Lender and Development Company Loan Programs, credit analysis and repayment ability requirements.
- Office of the Comptroller of the Currency. Comptroller's Handbook: Commercial Real Estate Lending and Rating Credit Risk.
- Interagency (2006). Interagency Guidance on Concentrations in Commercial Real Estate Lending, Sound Risk Management Practices. 71 Fed. Reg. 74580.
This guide is educational and does not constitute financial, credit or tax advice. Earnings, add-backs, debt service, rates, terms and coverage requirements are stylized illustrations; lenders define cash available for debt service and required ratios differently. SBA requirements are set by its current standard operating procedures, which change. Consult your lender and accountant.