What is Debt Serviceability Ratio and How Does it Affect Your Business?
A robust debt coverage service ratio (DCSR) can be one of the best friends you might not even know your business needs.
While the acronym contains some complex terms, DCSR can make all the difference when you’re ready to seek additional financing. But in order to understand DCSR better, let’s first take a look at what it is.
Put simply, your business’s DCSR is a measure used to calculate the cash flow available to pay toward its current debts.
To get the DCSR, you divide your business’s net operating income by its total debt service. However, when you are accounting for net operating income, there are a few less-obvious obligations to bear in mind as you consider all obligations due within a one-year period. Think: leases, interest, principal, etc. It’s also important to note that personal income and debt are sometimes included when making this calculation.
How it Works
For a hypothetical, real-time example, let’s consider Buddy’s Bakery. It’s a small town shop that competes in the local cupcake market. Thanks to rising customer demands, the owner (Buddy) is considering upgrading the bakery’s equipment as well as hiring more staff. He is also thinking about opening a second location in the next town. But before any of those things can happen, he needs a reality check to put his finances in order.
Per his accountant, Buddy’s has:
- A net operating income of $100,000.
- Debt obligations of $40,000.
- By dividing $100,000 by $40,000, his accountant determines Buddy’s Bakery has a DCSR of 2.50.
This is great news for Buddy and his business because most, if not all providers, favor businesses that have a DCSR of 1.25 or above. When they look at this number, it tells them that Buddy’s Bakery can cover all of its debt obligations. Sadly, this is not the case for Callie’s Cupcakes, a competitor with a DCSR of .95, which tells the provider it can only cover about 95% of its annual debt payments.
Implications and Remedies
A business’s DCSR eligibility has far reaching implications, including whether or not your business funding is approved. It also decides the amount and terms for which you are eligible. In the bakery showdown examples, Betty’s gains more favor than Callie’s.
But, all is not lost for Callie’s Cupcakes and businesses that discover they have less-than-favorable ratios. There are steps that, when taken, boost a DCSR. Businesses can boost this number by increasing their revenues and/or decreasing their business expenses and/or lowering their debts. It also turns out that providers tend to look favorably on a combination of all three steps.
If Callie manages to move the needle, it will be much easier to secure financing and stay competitive with Buddy, who, thanks to the healthy DCSR of his business, has hired more staff and is looking at empty storefronts.
When it’s time to seek additional financing, ensure your business is on the right foot by calculating this for yourself ahead of time if you can. It will make the conversation go much smoother and you will have a better idea about what to expect during your chat.