What is Debt Service Coverage?
If you look up the definition of “Free Cash Flow” in an accounting textbook you get this formula: Free Cash Flow = Net Operating Profit After Taxes − Net Investment in Operating Capital. To simplify this, it means the profit left over after paying (or setting aside money to pay) income taxes minus all of the stuff you plan to buy to invest in the business is what’s “free” for other purposes – like the cost of borrowing.
Lenders want you to have free cash flow left over after taking care of all those other business needs, like paying income taxes and making necessary investments in the business. To be sure you can pay back a loan, here’s the concept that really matters: Debt Service Coverage Ratio (DSCR) = Annual Net Operating Income / Annual Debt Service
Annual Net Operating Income means your gross revenue minus your operating expenses.
A lender computes your Annual Debt Service by adding up the payments you have to make for all of your debts, including principal and interest, including the loan you are requesting.
For small business owners, where commonly their own personal income comes from the business, a lender will also look at your “global” debt service. That means adding in your personal obligations such as mortgages, car payments, credit cards, etc.