As a business owner, you have to be obsessive about the amount of money your company is making. Ideally, your profit margin will be high, meaning you earn far more than you spend, which is known as positive cash flow. It can make a significant difference in your operational capabilities.
However, while positive cash flow is always good, the primary question for businesses with a growth mindset is whether it is good enough to receive a business loan to fund the next phase of expansion. To answer that, you will have to calculate your debt service coverage ratio (DSCR).
Because your company’s DSCR is vital to determining your lending options, we’re going to outline how to calculate it and how you can improve your rating.
What is a Debt Service Coverage Ratio?
Two factors go into your DSCR. The first is your business’s net operating income, and the second is the total debt obligation. Here’s a quick breakdown:
– Net Operating Income – The total earnings for your business after expenses (i.e., rent, marketing, raw goods and labor).
– Debt Obligation – The total amount you pay annually for all debts, including loans and credit cards.
An example might look like this:
– Annual Gross Income = $300,000.
– Annual Operating Expenses = $150,000.
– Net Operating Income = $150,000 (300,000 – 150,000).
– Annual Debt Obligation = $100,000.
– Debt Service Coverage Ratio = 1.5 (150,000/100,000).
Typically, a “good” DSCR is at least 1.25, although some lenders will want it to be 1.5 or higher. If your number is greater than that, your business is doing well. The closer you are to an even DSCR (i.e., 1), the harder it is to secure a loan. If you have a negative number, you need to make some changes as soon as possible to turn it around.
Benefits of a Good DSCR
This calculation only matters when trying to secure financing for a business loan. Lenders look at your DSCR to determine how well you can pay off debts. A higher number means that you can satisfy your obligations even if business dips.
There are several ways that a good DSCR can help your business:
– Higher Loan Amounts – If you have to take out a significant loan (i.e., six or seven figures), your DSCR has to be high enough to justify it. In most cases, this number will determine the maximum loan amount you can receive.
– Lower Interest Rates – A high DSCR means that your business is financially solvent, so you are much less of a risk. Lenders will charge far less in interest because they are not worried about late or missing payments.
– Preferable loan types or terms – Businesses with higher risk may not be approved for long-term financing. Instead, they may only be approved for loans with a short repayment schedule, leveraged hard assets or other terms less advantageous to the borrower. A high DSCR opens the door to more options for the borrower.
How to Manage Your DSCR During a Downturn
Unfortunately, even if your debt service coverage ratio is good right now, that may not always be the case. As 2020 has illustrated, factors beyond your control can derail your business plans without warning.
When times get tough, it is imperative to know the options available to you. Thankfully, working with a certified commercial loan broker can give you access to more lending possibilities, which can help you stay afloat during a downturn. Here are some ways to mitigate a falling DSCR:
Factoring
If you are unfamiliar with factoring, it can come in handy quite often, even outside of a recession. This process works by leveraging your outstanding invoices. A factoring company takes the invoice and pays you a lump sum upfront (usually up to 80 percent). From there, the factor contacts your client to secure payment. Once the client pays, you receive the rest of the funds, minus a fee.
Usually, factoring is ideal for managing your business’ cash flow when you’re waiting for customers to pay their balance. However, in a downturn, you may be able to cash in on invoices that would otherwise be paid months later.
Another form of factoring is contract financing. If you have a contract to deliver goods or services to a client, you can borrow against it for fast funding. This way, you can maintain operational efficiency without having to take out a loan.
The best part of factoring is that there are no credit checks or monthly payments. Since you would be borrowing money you would receive anyway, you don’t have to pay it back.
Equipment Sale-Leaseback
If you own high-end equipment for your business, you may not be using it as much during a downturn. Either that or the cost of upkeep and maintenance may be too high. A sale-leaseback can be a viable option to generate a cash infusion without losing the machinery.
This process works by selling your equipment to a leasing company and then signing a lease to continue using it. You get the cash from the sale, and now the leasing agent is responsible for repairs and upgrades. Best of all, the equipment does not have to leave the warehouse or job site, so your operations are unaffected.
Debt Consolidation
Finally, one way to increase your DSCR is to lower your debt obligations. If you are paying off multiple loans or credit cards, chances are that you have relatively high monthly payments. If you consolidate these balances with a single loan, you can pay less overall and potentially get a better interest rate.
Contact Us Today
Improving your debt service coverage ratio can have a significant impact on the future of your business. Working with a certified commercial loan broker ensures that you can find the right financing option to fit your needs. Call us today to see what we can do for your business.