How to calculate your business’s debt coverage ratio

Is your business generating enough income to cover the money it owes? One way to find out is by calculating its debt coverage ratio (DCR), also known as debt service coverage ratio (DSCR).

Here’s a closer look at what DSCR means for your business, why it’s important and how to calculate it.

What you’ll learn:

• The debt service coverage ratio (DSCR) helps business owners determine whether their company has enough money coming in to pay its bills. 

• Business owners can find out their DSCR by taking their earnings before interest and taxes (EBIT) or their earnings before interest, taxes, depreciation and amortization (EBITDA), and then dividing this number by debt service—the sum of debt payments, including principal and interest.

• Maintaining a healthy DSCR helps keep your business’s finances on track and builds trust with lenders and investors, but it does have some limitations, such as inconsistent results.

DSCR is a financial metric that gives a business insight into whether it’s bringing in enough cash from daily operations to cover any debt it owes. DSCR is a useful tool for determining whether your business’s current income can handle loan payments—including both principal and interest.

You can use DSCR to get a sense of your company’s overall financial health. If the ratio is high, you’re in a good position to handle your debt obligations and can possibly invest more of your revenue into growing your business. But if the DSCR is low, it may be time to look at ways to improve your cash flow. 

Potential lenders also take your business’s DSCR into account when deciding whether to approve it for a loan or line of credit. A strong DSCR lets them know your business is likely to make payments on time. You’ll often see DSCR terms in loan agreements, as they help protect the lender by showing that the borrower is financially stable.

Understanding the DSCR of your business is important because it’s a key indicator of the company’s financial health. It can help determine whether your business collects enough income to cover any fluctuations in cash flow. It also shows how well your business can handle its current debt and whether it’s in a position to potentially take on more. 

Keep in mind that managing cash flow can be tricky due to its fundamental unpredictability. Expenses might suddenly increase. Sales might slow down unexpectedly. Economic conditions may shift. But if you know your DSCR, you’ll have a better idea of the buffer you have to handle during uncertain times without missing payments.

If your company has a higher DSCR—which can be defined as anything above 1.0—it’s a clear sign you’re earning more than enough income to cover your debt obligations, including both interest and principal. But if your company’s DSCR is on the lower side—below 1.0—it suggests that your company is falling short and could have trouble keeping up with its debt payments. 

If your business has issues repaying its debt on time, potential lenders might find it too risky to deal with. On the other hand, a higher DSCR can improve your business’s chances of securing better loan terms, and it can open the door to more credit options. Investors also pay attention to your business’s DSCR because a healthy ratio signals that it is stable, profitable and can manage its obligations—all key factors for organizations considering making investments.

You can calculate the DSCR of your business by using a straightforward formula. First, you’ll need to know its net operating income, which is its revenue minus operating expenses. Some businesses use EBITDA for that number, but if you’re using EBITDA, you may also subtract cash taxes paid to get a clearer picture of your available cash. 

Then, you’ll divide that number by the total debt service. This includes all principal and interest payments your business must make over a year. To find this figure, add up all your monthly loan payments and multiply by 12.

Here’s a look at the DSCR formula:

Breaking down the formula:

• Net operating income: Refers to EBIT or EBITDA

• Total debt service: Includes all the principal payments and interest payments on the debt a business owes over a designated time frame, usually a full year

Here’s an example of a hypothetical business with a net operating income of $250,000 and annual debt payments totaling $200,000. That company’s DSCR calculation would be:

As shown above, this hypothetical business would be earning 1.25 times the amount required to cover its debt obligations. In other words, it’s bringing in 25% more income than needed to make its loan payments—a strong sign of good financial health. 

Broadly speaking, DSCR reveals the following:

• If the DSCR is above 1.0: The business can pay down its debt since it’s earning enough income. This is a positive sign that the business is in a stable financial position.

• If the DSCR equals 1.0: The business has reached its break-even point and is just able to meet its debt obligations. This isn’t necessarily bad, but it does leave less room for unexpected expenses.

• If the DSCR is below 1.0: A lower DSCR indicates that this business carries some risk because it’s not generating enough income to handle all of its debt obligations. The business may need to look into cutting costs, dipping into savings or seeking additional funding to avoid default. 

Here’s an example of a business with a lower DSCR: 

Lenders would likely view this DSCR score as risky, as this potential borrower shows negative cash flow. In this case, the organization may only be able to cover 89% of its annual debt payments.

Measuring the DSCR of your business helps provide a clear picture of how well it can handle its debt. Think of it like a financial health checkup—it helps illustrate whether your business has enough income to keep up with its loan payments. 

Knowing your DSCR provides these advantages:

• Insight into how comfortably you can pay your loans: A good DSCR lets you know that you won’t be scrambling to make debt payments. Plus, it helps you spot financial trends so you can avoid taking on too much risk by overborrowing.

• A way to compare your business with competitors: By looking at the DSCR of your top competitors, you can see where you stand financially and learn how they use loans to support their growth.

• Support for smarter long-term financial planning: Your DSCR helps guide budgeting, forecasting and investment decisions. Since it reveals your ability to meet debt obligations over a year, it provides an accurate, comprehensive view of your company’s financial health. 

Maintaining a healthy DSCR can help you stay on track while building trust with your lenders and investors.

While calculating DSCR is a helpful way to measure your company’s financial health, it does have some limitations. Here are a few potential drawbacks to keep in mind:

• It can be calculated in different ways. There’s no one-size-fits-all formula for calculating DSCR. Depending on lender requirements, some businesses use EBIT to measure DSCR, while others use EBITDA. Because of this, the results can vary. And depending on the calculation method, it might show a business to be healthier on paper than it actually is. 

• Not all expenses are included. DSCR focuses solely on a business’s income compared to its debt payments. This number might not fully consider other important factors, like taxes or changes in revenue. As a result, a company might look financially healthy according to its DSCR but still struggle with cash flow.

• Accounting rules might distort results. DSCR might suggest a business has enough income to cover its debt, even if the cash isn’t actually on hand yet. This happens because DSCR calculations often rely on accrual-based accounting, which counts income earned but not yet received—and expenses owed but not yet paid. Since debt payments require actual cash, the DSCR might indicate you can cover your loans when, in reality, the cash might not be available in your account when payments are due.

A good rule of thumb is that the higher the DSCR number, the more comfortable you can feel about your business being able to pay its bills. Most of the time, a good DSCR is any number above 1.0, since a 1.0 DSCR means your business has just enough income to cover its debt obligations, without having any money in reserve. 

But what’s considered a “good” DSCR can vary, depending on your competitors, your industry and how quickly your business is growing. Smaller or newer companies might have a lower DSCR as they’re still building revenue and cash flow, while well-established businesses in stable industries often maintain a higher DSCR—usually above 1.25.

Aiming for a DSCR above 1.0 is a good starting point, but to set realistic goals, it’s important to understand what’s regarded as typical in your industry.

Your business’s DSCR isn’t just a number—it’s a snapshot of how comfortably it can manage its debt. Whether you’re seeking a line of credit for your business or just trying to keep tabs on its finances, DSCR is an important ratio to keep an eye on. Just remember that it does have some limitations. You can get a clearer picture of your business’s financial health when you view DSCR alongside other financial metrics.

Capital One offers a variety of business credit cards to help you streamline your expenses and manage your finances. See if you’re pre-approved today, with no impact on your personal credit score.