In commercial lending, you’ll often hear about debt-service coverage, or the ratio between your business’s cash flow and debt. Simply put, it’s a method to determine whether your company is generating enough cash to pay all the debts that it has or might have if you’re looking at obtaining a loan. A commercial banker will review the ratio to help decide whether your company can handle loan payments.
To determine your debt-service coverage ratio, you’ll first need to determine your annual EBITDA figure; that’s your earnings before interest, taxes, depreciation, and amortization. If you haven’t done that yet, check out our blog and video on determining your EBITDA.
Once you have figured out your EBITDA figure, the next step is to determine what your monthly debt obligations are currently plus any additional debt that will be added. This includes equipment and auto payments, line of credit payments, real estate payments, and any other loans you are paying monthly through the business. Once you have totaled all your monthly loan payments that you have or are planning to have, multiple that number by twelve in order to get your annual debt obligation.
Now divide your annual EBITDA figure by your annual debt requirements. The results you come up with will either be greater or less than one. If you have a debt-service ratio of one or greater, then your company is making enough money to handle its debt payments. If the debt-service ratio is less than one, you are not taking in enough revenue throughout the year to make all your payments. You’ll need to either reduce your expenses or look for a way to increase your revenue.
Here’s an example of a fictional company:
Annual Debt Obligation $140,000
$150,000 ÷ $140,000 = 1.0714
In this example, XYZ Company has a debt-service coverage ratio of 1.0714, meaning it has 7% more income than is needed to cover current debts.
A commercial lender will review the debt-service coverage ratio to help make a determination if the company is generating enough income to cover any cash flow fluctuations. However, each lender will have their own acceptable debt-service coverage ratio. Some lenders may also require that your company reevaluate your debt-service coverage ratio on a yearly basis.
There are ways you can improve your debt-service coverage ratio:
- Increase your net operating income
- Decrease your operating expenses
- Pay off some of your existing debt
- Decrease your borrowing amount
Please contact any of our commercial bankers here at Peoples State Bank with questions on this material.