Debt Service Coverage Ratio (DSCR)

Debt Service Coverage Ratio is a metric often used by lenders to determine a company’s creditworthiness. You can think of it as an alternative credit score for businesses, as the DSCR formula serves pretty much the same purpose. Companies can even acquire loans based on their DSCR assessment, with interest rates ranging between 6.75% and 8.50% as of February 2025. In this article, we’ll explain the debt coverage service ratio loan meaning, how to calculate DSCR and use it in real life.

What Is a Debt Service Coverage Ratio?

The Debt-Service Coverage Ratio (DSCR) is a metric that evaluates how well a business can use its cash flow from operations to pay off its debt. It’s measured by dividing the net operating income of the enterprise by its entire debt service, including interest and principal payments. If a company’s DSCR value is greater than 1, it means the business is doing well and makes enough revenue to repay the loans. On the contrary, a ratio of less than one indicates potential debt repayment issues.

DSCR meaning is significant, and it’s more than just accounting. DSCR is often used by investors, lenders, and financial analysts to assess the financial standing and creditworthiness of a business. Lenders use this ratio to evaluate how much risk they’ll be exposed to, and adjust their interest rates and other loan terms accordingly. Investors and analysts use it to make informed choices when investing in a company, as it reflects whether the business can make enough money to pay off its debts.

Any loan assessed through the DSCR can be called a DSCR loan, although the term is primarily used in commercial real estate.

But, how can this ratio be used if you’re neither a lender nor an analyst? There are a few situations when you may apply it.

Applying for a loan

Lenders use DSCR to determine if a company can qualify for a loan, so if you know yours, you can accurately predict your chances when trying to get financing. If a DSCR is high, a business owner has more chances for approval because of their low default risk. If a company's DSCR is low, a lender may either deny the application outright or apply higher-than-average interest rates.

Business strategy planning

In many cases, DSCR is a good indicator of a company's overall financial standing, making it useful in business planning. Analyzing DSCR helps businesses determine whether they need to seek new sources of income and cut expenses to maintain financial stability or can handle more debt to speed up their development.

New investors engagement

A high debt service ratio can boost your chances of attracting investors because it demonstrates your debt-management capabilities. As a rule, investors prefer companies with a high DSCR because it indicates financial stability and a low probability of default.

Business valuation

DSCR also helps potential buyers assess whether a company has sufficient cash flow to pay its current debt. Usually, businesses with strong DSCR are popular among buyers.

Debt restructuring

Businesses experiencing debt overload can use DSCR to bargain with lenders for better repayment terms. A lender may offer refinancing or restructuring debt to reduce monthly payments if the company’s DSCR falls low enough.

Debt Service Coverage Ratio Formula

There are different formulas to compute DSCR, but here’s the most common and simple one:

DSCR = Net Operating Income / Total Debt Service

This formula divides the Net Operating Income​ by the total debt service to determine the number of times the operating income will be able to repay the debt.

Net Operating Income = Revenue - COE (certain operating expenses)

Net Operating Income is the income earned minus running costs, but without taking interest payments and taxes into account. It measures the amount of funds available for debt repayment.

Debt Service = Principal Repayment + Interest Payments + Rental Payments

Total Debt Service refers to total principal and interest payments required on existing debt during a specified term, usually annually. It represents the entire amount of debt that needs to be paid off.

How to Calculate DSCR

Let's apply the formula to a real-life situation. Imagine you own a hotel in a coastal city. You apply for a commercial loan of $2,000,000 with a 6% interest rate to expand your property. Your principal repayment is $300,000 per year.

The hotel generates $2,000,000 in annual revenue. The operating expenses include supplies, maintenance, salaries for staff, insurance, income tax, and property taxes. These costs add up to $1,200,000.

Now, let's calculate the company’s DSCR. First, we need to find Net Operating Income.

NOI = Annual Revenue - Operating Expenses

NOI = $2,000,000 - $1,200,000 = $800,000

The next step is calculating Total Debt Service.

Total Debt Service = Principal Repayment + Interest Payment

Total Debt Service = $300,000 + $100,000 = $400,000

Let's now enter these values into the DSCR formula.

DSCR = NOI / Total Debt Service

DSCR = 800,000 / 400,000 = 2

We’ve got a DSCR of 2.0, which means the hotel makes twice as much as it needs to pay back its loan. This high ratio shows that the company can easily pay back every obligation it currently has. Lenders would probably let this hotel qualify for borrowing under favorable terms, as they usually demand a minimum DSCR of 1.25.

DSCR Calculation Errors to Prevent

Now that we discussed the DSCR definition and formula, let’s talk about the errors to watch out for when calculating it. Even though the formula is simple, if you put the wrong numbers into it your results will be inaccurate.

1. Estimating the principal repayment amount inaccurately

People often input the wrong amount of principal because it can’t be found in balance sheets or corporate income statements. It’s a good idea to ask your financial institution to give you a repayment schedule for every loan. Also, you should always ask your accountant to check this information.

2. Pasting another measure instead of NOI

Sometimes, you might mistakenly insert Gross Revenue or Gross Profit in place of NOI. While gross profit is the money remaining after the cost of items sold before additional operating expenses, gross revenue is the whole amount of sales obtained without deducting expenses. This can lead to a misleading DSCR because the formula is not designed to deal with all operating expenses.

3. Forgetting to add real estate purchases or rent

If you own a business, you likely either own real estate property or rent one for your operations. It adds up to operating expenses. This will affect the debt service coverage ratio, especially if you’re currently paying off your mortgage.

Interest Coverage Ratio vs. DSCR

It’s important to understand DSCR loan meaning not just to calculate the DSCR correctly, but also not to confuse it with interest coverage ratio. Both metrics measure a company’s ability to manage debt, but they focus on different aspects. So, let’s compare ICR and DSCR.

ICR expresses how easily a company can cover the interest on its debt. To calculate it, divide earnings before interest and taxes (EBIT) by interest expenses. The higher the ICR, the easier a company can cover its interest payments, which is good for short-term financial well-being.

ICR = EBIT​ / Interest Expense

DSCR takes into account both the principal and the interest payments. It provides a better picture of how capable a company is of paying all its debts over a longer period.

The ICR is useful for determining short-term liquidity, while the DSCR helps identify overall debt repayment capacity. Both are used by lenders to calculate overall financial stability.

DSCR Loan Pros and Cons

But what is a DSCR loan, we hear you ask? Well, it’s just a loan with its terms based on DSCR, as simple as that. Let’s take a closer look at what such a loan can offer you.

Pros of DSCR Loans

• Agility: Businesses with lower credit scores can obtain necessary financing thanks to DSCR loans, which are computed differently from more conventional credit score-based loans.
• High LTV: DSCR loans are often considered to be low-risk, particularly when the DSCR limit is high, which means higher loan limits.
• Reduced interest: Many DSCR loans have lower interest rates compared to credit score loans because of the lower risk.

Cons of DSCR Loans

• Mandatory income: Having a consistent, stable income is essential for getting a DSCR loan, which makes it unsuitable for startups and other emerging businesses.
• Good financial standing: Companies that want to get a DSCR loan must have enough profits to cover the anticipated loan expenses and still retain enough funds to maintain normal operations.
• DSRA: You might be required to obtain a Debt Service Reserve Account to be granted a loan.
• Entrepreneurial capacities: Before approving a DSCR-based loan, lenders might require you to present proof of experience in the industry, so you should prepare a good business plan and some form of confirmation of your expertise in the field.

Businesses seeking funding and real estate investors need to comprehend DSCR. This ratio helps lenders analyze loan eligibility and risk. DSCR loans offer flexibility but demand reliable income and a healthy financial situation. To make wise financial choices, companies must calculate DSCR correctly, avoid mistakes, and compare it with other metrics like the Interest Coverage Ratio.