Category: Business Loans
Resource type: Test
What This Test Answers
Does your business earn enough to cover its loan payments with room to spare? Lenders answer this with the debt service coverage ratio (DSCR). This test shows you how to calculate it before you apply, how much cushion you have, and how large a loan your cash flow can actually support.
The Formulas
Step 1: Net operating income (NOI)
NOI = Revenue − Operating Expenses
Operating expenses include rent, payroll, supplies, insurance, and utilities. Leave out interest, income taxes, and depreciation.
For small businesses, lenders often start from net profit and add back interest, depreciation, and amortization:
Cash Flow Available = Net Profit + Interest + Depreciation + Amortization
Owners of sole proprietorships and partnerships may also add back a documented owner's draw or salary, but lenders vary on how they treat it. Ask before you assume it counts.
Step 2: Annual debt service
Annual Debt Service = Total yearly principal and interest payments on all business debts, existing and proposed
Monthly payment formula for the proposed loan:
M = P × [r(1 + r)^n] ÷ [(1 + r)^n − 1]
- P = loan amount
- r = monthly rate (annual rate ÷ 12)
- n = number of monthly payments
Annual debt service = M × 12.
Step 3: DSCR
DSCR = Cash Flow Available ÷ Annual Debt Service
Step 4: Cash cushion
Cushion ($) = Cash Flow Available − Annual Debt Service
Step 5: Maximum affordable debt service
Maximum Annual Debt Service = Cash Flow Available ÷ Target DSCR
Step 6: Revenue stress test
Stressed Cash Flow = Cash Flow Available − (Revenue × Revenue Drop % × Contribution Margin)
Stressed DSCR = Stressed Cash Flow ÷ Annual Debt Service
Contribution margin is the share of each sales dollar left after the direct costs of making that sale. It reflects how much profit you lose when sales fall.
Worked Example
The scenario
A café owner wants a $150,000 loan to buy equipment and add seating.
| Item | Annual Amount |
|---|---|
| Revenue | $620,000 |
| Net profit | $58,000 |
| Interest on existing debt | $6,000 |
| Depreciation | $12,000 |
| Cash flow available | $76,000 |
| Existing debt payments (principal and interest) | $22,000 |
Proposed loan: $150,000 at 9.00% for 7 years (84 months)
Step 1: Payment on the new loan
- r = 0.09 ÷ 12 = 0.0075
- n = 84
- M ≈ $2,413.60 per month
- Annual: $2,413.60 × 12 ≈ $28,963
Step 2: Total annual debt service
$22,000 + $28,963 = $50,963
Step 3: DSCR
$76,000 ÷ $50,963 = about 1.49
Step 4: Cushion
$76,000 − $50,963 = $25,037 per year
Step 5: Reading the DSCR
| DSCR | What it means |
|---|---|
| Below 1.00 | Cash flow does not cover payments |
| 1.00 to 1.19 | Covers payments with almost no room for error |
| 1.20 to 1.24 | Meets a common minimum at many lenders |
| 1.25 and above | Generally viewed as healthy |
| 1.50 and above | Strong; better odds of approval and pricing |
Lender minimums vary by lender, loan type, and industry. Many commonly look for somewhere between 1.15 and 1.35.
Result: At 1.49, this business clears the usual minimum with room to spare.
How Much Can You Borrow?
Using a target DSCR of 1.25:
Maximum annual debt service
$76,000 ÷ 1.25 = $60,800
Room left for new debt
$60,800 − $22,000 existing = $38,800 per year, or $3,233 per month
Maximum loan at 9% over 7 years
Payment per $1,000 borrowed ≈ $16.09 per month, so:
$3,233 ÷ $16.09 × $1,000 ≈ $201,000
Reading the result: The café's cash flow could support about $200,000 of new debt at a 1.25 target. The requested $150,000 sits comfortably inside that.
Revenue Stress Test
Assume a contribution margin of 40%, meaning each lost sales dollar costs about 40 cents of cash flow.
| Revenue Drop | Revenue Lost | Cash Flow Lost | Stressed Cash Flow | Stressed DSCR |
|---|---|---|---|---|
| 0% | $0 | $0 | $76,000 | 1.49 |
| 5% | $31,000 | $12,400 | $63,600 | 1.25 |
| 10% | $62,000 | $24,800 | $51,200 | 1.00 |
| 15% | $93,000 | $37,200 | $38,800 | 0.76 |
Reading the result: A 10% sales decline takes this business to break-even on debt service, and 15% leaves it short by about $12,000 for the year. The loan passes the lender's test but has a thin cushion against a weak season.
Worksheet Summary Table
| Line | Item | Example | Yours |
|---|---|---|---|
| A | Net profit | $58,000 | |
| B | Add back: interest | $6,000 | |
| C | Add back: depreciation and amortization | $12,000 | |
| D | Cash flow available (A + B + C) | $76,000 | |
| E | Existing annual debt payments | $22,000 | |
| F | Proposed annual payments | $28,963 | |
| G | Total annual debt service (E + F) | $50,963 | |
| H | DSCR (D ÷ G) | 1.49 | |
| I | Cushion (D − G) | $25,037 | |
| J | DSCR after 10% revenue drop | 1.00 |
How to Improve Your DSCR
- Lengthen the term. A longer term lowers annual payments. The trade-off is more total interest.
- Borrow less or put in more of your own money. A smaller loan means smaller payments.
- Pay off or consolidate existing debt. Retiring small loans raises the ratio quickly.
- Raise cash flow. Trim costs, adjust pricing, or collect receivables faster.
- Shop rates and fees. A one-point lower rate on a large loan reduces annual payments noticeably.
- Document add-backs. One-time expenses and owner compensation can raise cash flow if you can support them with records.
Common Mistakes
- Leaving out existing debt. Lenders count every business debt payment, and often personal debt too for small businesses.
- Using revenue instead of cash flow. DSCR is built on profit, not sales.
- Forgetting interest and fee costs. Use the full payment, not just the principal.
- Overstating add-backs. Lenders may reject items you can't document.
- Treating the minimum as the goal. Passing at 1.25 can still be tight in a slow quarter.
- Skipping the personal side. For sole proprietors and small firms, lenders often review personal credit and personal DTI too.
Reader Checklist Before You Apply
- Pull your last two to three years of profit-and-loss statements and tax returns
- Total every existing debt payment, business and personal
- Calculate DSCR with and without the proposed loan
- Run the test at 1.25 and at your lender's stated minimum
- Run the revenue stress test at 5%, 10%, and 15%
- Ask the lender how it treats owner pay and add-backs
Lending Logic Lab provides educational information, not personalized financial advice. Confirm your figures with your lender.
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