Debt Service Coverage Ratio (DSCR) and SBA 504 Loans

In order get approved for an SBA 504 loan, you must prove your company’s ability to repay it. A business plan and the necessary financial documents play a role in that. However, most underwriters will use a debt service coverage ratio, or DSCR, as a major element in their decision-making process.

What is a debt service coverage ratio? It’s nothing more than the amount of cash flow available to meet annual interest and principal payments on any new debt that might be incurred, as well as existing debt. Your lender will use a specific formula to arrive at a ratio that represents your ability to repay your debt. The formula looks like this:

• Earnings before interest expenses

• Taxes

• Depreciation and amortization

• Rental expenses

• Rental income (if applicable)

Added together, these give you your company’s “cash available” amount. Against this, you have:

• First mortgage

• Second mortgage

• Existing debt

These are added together to give you your “total debt service”.

The final formula looks like this:

DSCR = Cash Available / Total Debt Service

In most instances, lenders want to see a DSCR around 1.2:1 or higher. In other words, your income is 1.2 times higher than your total debt service, meaning that your cash flow is positive and you should have no issues repaying the loan.

Note that there is no standard DSCR requirement that applies with all lenders. Each lender will have their own unique requirements that you must meet. For instance, one lender might allow you to have a DSCR for the preceding year, but require a DSCR of 1.2 or higher for the current year.

While your lender will calculate your DSCR in the pre-approval process, you can take preemptive action and get a good idea of where you stand by calculating it on your own. The formula listed above will help you do that, but there are a few common mistakes that you need to avoid in the process.

Common Mistakes When Calculating Your Own DSCR

Business owners and entrepreneurs can and do make several mistakes when trying to calculate their own DSCR. Perhaps the most common is not accounting for existing business debt. It’s tempting to simply take all your income into account, but only account for the new loan. That won’t work. Lenders will need to see all of your business debts, not just the one you’re applying for.

Another mistake here is that business owners do not realize what counts as business debt and what does not. For instance, any business line of credit is technically a debt. Any business credit cards with a balance will count, as well. Any leases (including leased equipment or vehicles) will count as debts, as will any invoice financing you might have used. Finally, all short-term loans will be also be counted by your bank.

What a lender really wants to see here is that your business is likely to bring in more than enough money to pay for your debts. They want you to continue to grow and flourish – making the bare minimum necessary just to pay your bills is not enough.

Obviously, if your DSCR is too low, it means that a lender will not be willing to take a risk on you, even with the SBA’s backing. A low DSCR means that your business would struggle to repay the loan on top of your existing debt, and that there is a greater chance of default in your situation. You may also have to worry about your personal credit, as some lenders use what’s called a global DSCR, which accounts for both your business income and debt, as well as your personal income and debt. The good news is that you can increase your DSCR in a few ways.

Improving your DSCR

Before you attempt to improve your debt, take a look at your estimated DSCR and see where you stand. Depending on the ratio, you may have just a little bit of work, or you may need to put in a good deal of effort.

If your DSCR is under 1:1, then you do not have enough cash flow to meet your current debt obligations, much less a new loan payment. You have a great deal of work to do here.

If your DSCR is 1, then you are making just enough to cover your current debt load. You will most likely not be approved for a loan unless you move that ratio up a bit. For instance, even the SBA requires a DSCR of 1.15 for 7(a) loans (not for 504 loans, though).

If your DSCR is higher than one, you are in good shape. You bring in more income than you have debt payments, meaning that you’re a great candidate for a loan.

As a final note, your lender may not actually worry about your DSCR. Some banks do not check DSCR on SBA loans – they only use this method on traditional loans. Many online lenders do check DSCR, though. Not sure if the lender you’re interested in working with uses DSCR? Check their business loan requirements. In general, the larger the loan you’re interested in, the more likely DSCR will be used. The smaller the loan, the more likely the focus will be on your personal financial history instead.

Now that we have covered that information, let’s look at a few ways that you can actually improve your DSCR. Even if it does not play a pivotal role in your financing, it is a good indication of your company’s financial health. After all, if your DSCR is under 1, then you’re not even treading water. It is in your business’ best interests to improve your financial situation even if you were not applying for a loan.

So, how do you go about improving your DSCR? There are a couple of options:

• Improving Business Revenue: Perhaps the single best way to improve your situation is to boost your revenue. Of course, that is easier said than done in many circumstances. If you’re struggling with bolstering revenue, consider the following:

• Increasing Prices: Even a modest price increase can have big ramifications for your financial situation if your sales volume is good.

• Higher Pay/Contract Rate: If you contract out on jobs, you can try to negotiate a higher pay rate.

• Lower Operating Expenses: Another option available to business owners is to reduce your operating expenses, which can be a good way to “trim the fat” so to speak, anyway. Some examples of expenses that you could possibly eliminate include:

• Negotiating lower rent with your landlord

• Cut back on staffing or payroll hours

• Reduce marketing spend

• Reduce unnecessary or little used leases (equipment, vehicles, etc.)

• Cancel services that are little used or not used at all

• Outsource business responsibilities rather than hiring staff

• Pay invoices early to take advantage of discounts

• Work with your accountant to identify other cost-cutting measures

Even if you are not able to immediately improve your DSCR, you may be able to show the lender your plans for changes and financial projections on how much you will save once those changes are implemented. In some cases, this may be enough to convince them that you are a good risk.

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