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How to Correctly do a Debt Service Coverage Analysis (DSCR)

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A good debt service coverage ratio analysis is the primary factor in demonstrating a business’s ability to meet its debt obligations. To complete a debt service analysis, lenders calculate the debt service coverage ratio (DSCR). DSCR may seem simple enough, Cash Flow Available divided by Debt Service, but ensuring a debt service coverage ratio formula for banks accurately represents the business’s ability to pay its debts may require a number of adjustments, especially for small business lending.

Determining Available Cash Flow In A Debt Service Formula

The first step in an ideal debt service coverage ratio for banks is figuring out the cash flow available for debt service (CFADS). Lenders can use EBITDA (Earnings before interest, taxes, depreciation and amortization) or NCAO (net cashflow after operations) from a cashflow analysis like UCA. While UCA NCAO is often a more accurate calculation of CFADS, smaller businesses typically do not have the detailed financial statements necessary to use it. Regardless, either can be used in a debt service formula.

debt service coverage ratio formula for banks

In either case, remember that these values do not take into account dividends and distributions given to owners, those may need to be subtracted out. If not, you run the risk of cash flow being double-counted in the Global Cash Flow Analysis, once by the business as cash available for debt service and then by the owner as a part of his or her operating income. Additionally, a business may be obligated under its operating agreement to distribute some portion of Net Profit to its owners, meaning that cashflow is not available for debt service and should be backed out as well. The same situation applies to other owned businesses. It is not uncommon for a small business owner to borrow and lend money to different businesses or even to themselves. All of this must be accounted for when determining cash flows.

Factoring in Unusual Expenses

Next, you need to make any necessary adjustments to CFADS from your cash flow statement. Specifically, unusual, one-time events such as a significant expenditure or an unexpected influx of cash that are not representative of the businesses’ annual cash flow. For example, perhaps a business (small restaurant) had to purchase personal protective equipment due to the COVID-19 pandemic. That should not be an annual expense, but a one-time expenditure necessary to remain in business during a global crisis. It would not impact the business’s CFADS reality in a typical year and could be added back for a more accurate picture.

Another example might be litigation. Perhaps the business was unjustly sued, and the litigation resolved in their favor. Associated legal expenses could signify a one-time drain on the business that should not hamper its ability to pay off debt in the future. Analyzing several years’ of statements helps identify these one-off events to present a clearer picture of CFADS.

An Accurate Revenue Picture

The flipside is one-time influxes of cash that also do not represent the yearly reality of the business operations. Perhaps a significant piece of equipment was sold off, generating substantial revenue. This is not representative of dependable future income, and should be backed out of the CFADS calculation.

Similarly, certain capital campaigns or the receipt of grant income, such as the PPP loan program in 2020, are non-recurring sources of revenue, and the lender should consider whether to exclude them from CFADS.

debt service coverage analysis

Identifying Existing Debt

After figuring out the CFADS, it is time to determine the debt service itself. The most traditional method of calculation is to look at interest expense from the income statement and the current portion of long-term debt (CPLTD). The CPLTD number for this year’s debt service calculation should be taken from last year’s balance sheet, since it’s the portion of long-term debt due to be paid in the next 12 months. Of course, many small business owners are not familiar with the concept of CPLTD and do not report it on their balance sheets.

A common solution is to use a debt service schedule – a list of current debts and loans – held by the business. This may simply amount to a monthly debt payments list, but if you multiply that monthly list by 12, you have some idea of the annual debt load for the business.

Proposed Debt

Once you have the sufficient cash flow available for debt service, along with the debt service, you can calculate the existing or historic DSCR, but you’ll still need to incorporate the debt service from the new loan request (assuming there is one) to calculate the DSCR (Proposed or Pro-forma).  The Purpose of the new loan may also impact the calculation, like when a business that has been renting its space requests money to purchase it instead. In such a scenario the historic rent expense may need to be added back to CFADS. 

Contact FISCAL

Every one of the above tweaks and adjustments represents yet another example where Excel-based spreading can introduce errors into DCSR formulas in banking or tie you down in double-checking to be sure no mistakes were made.

If you need help with your debt service coverage analysis, or just think your process could be more efficient, reach out to FISCAL! With over 30 years of experience, we understand what your priorities are. Our financial spread analysis tools automate repetitive processes, allowing you to focus on your business. We believe that the tools you implement should be flexible to the way you do business! 

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