Debt Service Coverage: What it is and how to manage it

Want your business to exude financial responsibility, get better financing terms, and be set up for the best growth and stability? Keeping a strong DSC ratio can help with that. Debt Service Coverage (DSC) is a key financial metric showing whether your business generates enough cash flow to cover its debt, including principal and interest payments. A higher DSC ratio means your business can more easily manage debt, making it less risky for lenders and investors to work with you.

At Brady CFO, our team understands the importance of DSC and how to improve this ratio to ensure a business remains financially strong. We work closely with clients to analyze cash flow, identify areas for improvement, and implement strategies that boost financial health.

Generally, a DSC ratio of EBITDA at 1.25x principal + interest payments is considered healthy. This means your business makes 25% more income than needed to pay off its debt. So, let’s talk about how to calculate, forecast, and manage your DSC effectively.

Why is Debt Service Coverage important for businesses?

DSC tells you whether or not you produce enough cash from your core business functions to cover all your outstanding debt obligations. But why is that so important? It comes down to lending. Banks willing to offer credit lines to businesses often base their decision on that company’s historical and projected debt service capabilities.

If they believe there’s a risk in your ability to meet debt obligations, they may deny your application or offer less favorable terms. A strong DSC ratio demonstrates financial stability and reduces perceived risk, making securing necessary funding at better rates easier for your business. Not only does it look good to the bank, but maintaining a healthy DSC ratio also safeguards your company against unexpected downturns by ensuring you have enough cash flow to manage debt, even during challenging times.

How to calculate your Debt Service Coverage Ratio

Debt Service Coverage Ratio (DSCR) is calculated by dividing your EBITDA (earnings before interest, taxes, depreciation, and amortization) by your principal and interest payments on all business debt.

EBITDA

EBITDA is a general measure of cash flow from a company’s primary operating activities. It measures a business's ability to produce cash flow from its normal business activities and doesn't include cash flow from selling equipment, raising capital, etc.

Principal + interest payments

You want to determine how much principal + interest has been paid during the same time you measure EBITDA. Total principal payments can be calculated using the following method:

• Find outstanding debt balances on your balance sheet at the beginning of the period.
• Determine the balance change at the end of the period; the difference is your total principal paid.
• Account for new debt acquired during the period, including the amount paid down on any new debt.

Interest payments are a little more elusive. You can see the “Interest Expense” section on your income statement. But, if you accrue interest without paying interest on any loans, your Interest Expense will not represent actual interest payments. But, in my opinion, it's okay to go ahead and include what has been recorded in Interest Expense as a conservative measure. Otherwise, you’ll be left to look at all the loan payments you made and add up the interest from each loan statement associated with each payment. (Extremely tedious and typically not necessary!)

How to forecast your Debt Service Coverage Ratio

To forecast your DSCR, you need first to forecast your EBITDA for the next 12 months. The best way to do this? Predict revenues and expenses and then add your forecasted interest, depreciation, amortization, and income tax obligations.

Then, forecast all your debt payments for the next 12 months. To streamline this, have your accountant help you retrieve the most recent loan statement for each loan. The loan statement will identify the total amount of your monthly, quarterly, or annual loan payment (principal + interest). Next, you forecast the total debt payments expected over the next 12 months using the payments shown on your loan statements.

Finally, take your total forecasted EBITDA for 12 months and divide it by your total forecasted debt payments for 12 months. This will give you a good idea of your ratio over the next year.

How to manage your Debt Service Coverage Ratio

If your business is upside down on this calculation, you must either amplify your EBITDA (increase the numerator) or refinance your debt (decrease the denominator).

1. Increase EBITDA: You can do this by either cutting costs or trying to manage the proportion of costs vs. revenue while you increase revenue. So, as an example, if your payroll cost is 60% of revenue and your revenue is $10 million, you would work to maintain that ratio but grow your revenue to $12 million.
2. Manage debt: There are two major ways to manage debt:some text
   1. Sell assets or use liquid cash to pay down debt to reduce how much debt you owe, thereby reducing your total forecasted payments in the future.
   2. Refinance your existing debt so your regular payments are lower in the next 12 months.

At Brady CFO, our team has directly helped clients manage their debt service to successfully meet their banks' loan covenants. One of the ways we recently strategized with a client was to sell some real estate holdings to pay off existing debt, allowing them to maintain their credit line and ensure they could handle seasonal swings of cash flow in the business.

We help businesses maintain optimal liquidity and financial health by strategically managing assets and liabilities. This proactive approach enables our clients to meet lender requirements, avoid potential penalties, and have sufficient working capital to navigate periods of fluctuating income.

If you're struggling with financial stability, consider your Debt Service Coverage. Effectively managing DSCR will keep things running smoothly and give your business the breathing room to grow and thrive!