Debt service coverage explained

On this page

• The formula takes one line
• SBA sets floors, and each lender sets its own
• A worked example: how much loan your cash flow supports
• Stress test the ratio before you borrow
• History comes before projections
• Five ways to raise the ratio before you apply
• Your loan agreement may add a covenant
• When a passing ratio is still a warning

The formula takes one line

Debt service coverageDebt service coverageCash available for loan payments, divided by those payments. Above 1 means the cash covers them. Full definition is cash flow available for debt payments divided by the debt payments due. A ratio of 1.50 means $1.50 of cash flow for every $1.00 of payments. At 1.00 you break even. Below 1.00 you cannot make the payments from cash flow.

SBA defines debt service as the future required principal and interest payments on all business debt. That includes the new loan (SOP 50 10 8.1, Sec. B, Ch. 1, Para. C.2.a). The lender also wants a debt schedule that lists any shareholder debt. Cash flow starts from EBITDA, then the lender adjusts it.

SBA sets floors, and each lender sets its own

SBA sets minimum ratios, and each lender sets its own policy on top of them:

• Standard 7(a): 1.15:1, on historical or projected cash flow, and 1:1 on a global basis.
• 7(a) Small: 1.10:1, which does not apply to changes of ownership.
• Business purchases: 1.25:1 for initial acquisitions and owner buyouts, and 1.15:1 for business expansions (Appendix 15, Para. C.2.b).

A global analysis looks past the business to the owners and any related businesses. For a purchase, SBA requires the owner's pay to cover the owner's own obligations and living expenses.

These are floors. A lender's policy varies by lender and can be higher. The OCC tells banks that the right ratio depends on the loan's amortizationamortizationPaying a loan down on a schedule, so each payment covers interest and part of the balance. Full definition period and on how volatile the cash flow is. It adds that owner-occupants with uneven earnings may warrant a higher ratio.

A worked example: how much loan your cash flow supports

Work backward from your cash flow to find the loan it supports. Suppose your business produces $240,000 of cash flow for debt payments. You already pay $60,000 a year on other loans. The lender wants 1.25 coverage.

1. Divide cash flow by the ratio: $240,000 divided by 1.25 is $192,000. That is the most total debt payments the lender will allow.
2. Subtract existing payments: $192,000 minus $60,000 is $132,000. That is $11,000 a month for a new loan.
3. Convert the payment to a loan size. Use 10 years at 10% for the arithmetic, not as a quote. Each $100,000 borrowed costs $1,322 a month. So $11,000 supports about $832,000.

The same cash flow supports different loans at different ratios. At 1.15 coverage it supports about $938,000. At 1.35 it supports about $743,000. A shorter term cuts the loan: over 7 years instead of 10, each $100,000 costs $1,660 a month.

Stress test the ratio before you borrow

A ratio above the minimum is a cushion, so test how big it is. The OCC tells banks to stress-test coverage ratios for the same reason (Comptroller's Handbook, Commercial Real Estate Lending, p. 42).

Suppose you have $240,000 of cash flow and $160,000 of payments, the $60,000 plus a $100,000 payment on the new loan. Coverage is 1.50.

• Cash flow falls 15%: it is $204,000 and coverage is 1.28.
• Cash flow falls 20%: it is $192,000 and coverage is 1.20.
• Cash flow falls 30%: it is $168,000 and coverage is 1.05.
• Cash flow falls by a third: it is $160,000 and coverage is 1.00, with no cushion left.

A business at 1.25 has less room. A 20% drop in cash flow takes it to 1.00. Size the loan so a bad year does not break it.

History comes before projections

SBA lenders start from history. For an existing business, the lender measures coverage on the most recent full year and the interim statements. If those do not show enough coverage, the lender must get two years of detailed projections. It must also explain why projections can stand in for history (SOP 50 10 8.1, Sec. B, Ch. 1, Para. C.2.a).

On a Standard 7(a) loan, start-ups and other projection-based applications must show 1.15:1 within two years of funding. On construction projects the two years run from the end of construction. Projected coverage may not count rent you expect to collect from the project property. A 7(a) Small loan can use 12-month projections that reach 1.10:1 within one year (Sec. B, Ch. 2, Para. C.2.a).

Five ways to raise the ratio before you apply

• Borrow less. More equity lowers the loan and the payment. On a purchase, SBA lets you add equity to close a coverage gap.
• Lengthen the term within SBA's limits. It lowers the payment but raises total interest. At an assumed 10% on $100,000, 10 years costs about $58,600 in interest and 7 years about $39,400.
• Replace costly short-term debt. Daily and weekly payments on advances and cards weigh heavily on the ratio.
• Document your add-backs. An adjustment the lender accepts raises cash flow. One it rejects does not.
• Avoid new debt before you apply. Every new payment goes into the bottom of the fraction.

If a lender has already declined you on coverage, see why business loans get denied.

Your loan agreement may add a covenant

Some loan documents include a coverage covenant, a promise to keep the ratio above a set level after closing. Read how the agreement defines cash flow and debt payments.

The OCC notes that coverage calculations for a covenant may differ from the ones used for underwriting. It says loan documents should define income and expenses clearly (Comptroller's Handbook, Commercial Real Estate Lending, p. 42). A covenant that you break can put the loan in default even when you pay on time.

When a passing ratio is still a warning

• Seasonal or lumpy cash. A yearly ratio can pass while a slow quarter runs short. Match the payment calendar to your cash calendar.
• A balloon or an interest-only period. The ratio can look strong while the payment is low, then break when it jumps. SBA does not allow balloon payments, but some bank loans have them.
• Cash flow that depends on one customer. If that customer leaves, the ratio falls.
• Coverage computed before your own pay. If your pay is not in the math, the ratio overstates what the business can afford.
• Debts outside the business. A global ratio includes them, and so does your household budget.