What is debt service coverage ratio?

The debt service coverage ratio (DSCR) is critical to loan approval. 

This is how it is calculated:

Annual EBITDA / Annual Debt = DSCR

For startups this is based on projections. For purchasing a business this is based on the combined profit of the buyer and seller. 

This ratio is a reflection of available free cash flow after paying all expenses and debt service payments.

The minimum DSC ratio required, when and if a policy exception can be made, and exactly how the DSC is calculated will all vary by lender. 

Many acquisition deals cash flow high enough that these variances won’t make a difference for acquisition loan approval. 

However, when cash flow is tight and every dollar counts, the lender’s minimum DSC requirement can make a difference between qualifying with one lender but not another.

Most conventional lenders will have a minimum of 1.5 to 1.75 DSCR (Debt Service Coverage Ratio) minimum. The SBA mandates a 1.15 business DSCR minimum but most SBA lenders will have a higher minimum ranging from 1.25 to 1.75 DSCR.

Lenders will calculate DSC for both the acquisition deal and for the borrower personally. Unfortunately the ways cash flow is calculated is not an exact uniform policy across the board with all lenders, even with SBA lenders. 

To calculate EBITDA for acquisition loans, the bank will typically take the combined buyer and seller net operating income (earnings) and add to it any interest, income tax, depreciation, and/or amortization expenses. 

They add the new acquisition loan debt and then look both forward a year and backward a year (often two years) to see if the deal cash flows above their minimum DSCR on a projected and historical basis.

Sometimes it isn’t only what the minimum debt service coverage ratio is but also how the DSCR is calculated.

Most SBA lenders will go off of EBITDA.