In today’s economy, lenders want to be especially sure your company has the ability to repay its debts, both short-term and long-term. The most critical measurement lenders are using right now is debt service coverage ratio (DSCR). It is currently the Holy Grail for measuring your ability to repay a loan. Obviously there must be adequate collateral and a few other factors too, but DSCR seems to be the measurement that business owners have the most difficulty understanding when applying for a loan.
1. DSCR is normally calculated as a snapshot of annual net operating income (NOI) as a percentage of total current and proposed debt.
It is mathematically expressed: NOI/Total Debt Service
2. A DSCR of 1:1 means your company is operationally breaking even. Less than 1:1 indicates you are generating less income than you need to support our debt. Lenders today are looking for a DSCR measured on an annual historical basis of 1.25:1. Stated another way, you must have 1.25 times more net operating income than you have existing and proposed debt in order to qualify for a loan.
3. In order to compare companies in different industries, banks often use earnings before interest, taxes, depreciation and amortization (EBITDA) as the basis for determining NOI. While not exactly the same, they are very close. The benefit of thinking about NOI as EBITA allows you to easily look at your financial statements and “add back” the items that are omitted in the calculation of NOI.
4. When you take your EBITDA figure and also add back capital expenditures (CAPEX) you have the measurement of operational cash flow which is increasingly being discussed with borrowers when setting loan covenants for large loans.
5. A few lenders will allow additional “add-backs” when calculating operational cash flow, NOI and DSCR. Examples include one time costs to a company that are “non-operational.” An example would be one time costs to prosecute a patent infringement, or a loss caused by a disaster such as an earthquake or tornado.
Knowing these terms and how to calculate EBITDA, NOI, and DSCR will make you a stronger financial manager. Setting your own goals for EBITDA and DSCR will help you position your company for easier and less expensive borrowing.
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