In the world of corporate finance, you’re going to hear a lot about DSCR, otherwise known as Debt Service Coverage Ratio. If you have ever bought a home, you might have had your debt to income ratio calculated, and this is a similar number, just on an individual level.
Knowing your DSCR and how to optimize the DSCR will allow you to obtain financial loans more easily and also get better interest rates.
What is the DSCR?
The DSCR will measure your cash flow that is available to pay off all of your current debt obligations. The ratio will identify your operating income as the debt obligations due within a single year. This will include:
- Lease payments
- Sinking-fund payments
DSCR is calculated simply. Take your net operating income and divide it into your total debt service.
If the number is greater than 1, then you have sufficient income to pay off all of your debt obligations. If you do not, then it can spell big trouble. Anything less than 1 means you have negative cash flow. You don’t want to be in this kind of situation because it means you’re unable to make a full year of your annual debt payments.
How to Improve Your DSCR
There are a lot of things you can do in order to improve your DSCR. Before you become too concerned about a number that is less than 1, remember that not all lenders will calculate the same way. For example, income taxes are complicated because the interest payments are tax deductible. The principle payments, however, are not.
You can start by monitoring your DSCR. Your income may increase and decrease throughout the year and thus your DSCR will change. The goal is to maintain a level of 1.25 or higher. If it shows you drop below this number at any point, you can then take action.
Increase your cash flow. This sounds easier said than done, but if you have a lot of outstanding debt, you have to do something in order to improve your current financial situation. Perform a good forecast so you can see where your cash flow is and whether it’s realistic to follow for the rest of the year. If you work on an accounts receivables basis, be sure you have a reliable collections system that works – and file disputes quickly.
To increase cash flow, it should also be a companywide priority. This means exploring ways to cut back spending so more flows down to the bottom line. It also means looking at ways to generate more revenue, such as adding a new service or product. Exploring your demographic is vital, too, as you may be missing out on an audience that you hadn’t thought of before.
You should also look at the lenders you use. If higher interest rates are in place, you will spend more on interest than on principle. This means you’re going to take longer to pay down the debt, leaving you with a problematic DSCR for a longer amount of time.
If you can choose lenders with lower interest rates, or even asking lenders if they can drop your current APR, it might be what’s needed to pay down some of the debt faster. This will leave less debt for you to calculate in against your total annual revenue.
Understanding your DSCR is an important part of being financially responsible, regardless of who you are. When the number calculates to less than 1.25, begin working on ways to improve the state of your finances so you don’t run into lending issues or any financial problems throughout your journey.