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What Are DSCR Loans and How Do They Work?
DSCR loans are becoming increasingly popular in today's market. Instead of using your credit history, your eligibility for a DSCR loan is calculated using the projected income of the assets you'll be purchasing with the loan.
Lenders and investors constantly seek to mitigate risk. For this reason, when looking at business loans, considerable importance is placed on the business credit report. Many banks and other lenders consider credit history an essential metric in understanding the trustworthiness of your business, as it shows your reliability in making payments as well as your current debt burden.
However, a credit history report does not provide a complete picture of a company and larger businesses looking for more significant finance must often bolster this risk assessment with further guarantees. Asset-based finance, therefore, becomes a stepping stone for businesses looking to leverage loan capital for growth.
In this blog:
Interest Coverage Ratio (ICR) vs. DSCR
What is a DSCR Loan?
The term DSCR loan can apply to any loan where DSCR is the primary way the lender determines applicant suitability, however, it has long been used in the commercial property industry and so is often tied to that sector.
DSCR is becoming a more popular way to determine credit suitability and it is possible to get DSCR loans in most industry sectors.
DSCR is a financial metric used to assess a company's ability to cover its debt obligations with its operating income. This simple calculation plays a significant part in showing a company’s ability to make repayments. It can be used either alongside the business credit report or in place of it to determine loan suitability.
The ratio is calculated by dividing a company's operating income by its debt service obligations (including interest and principal payments).
The higher a business’ DSCR value, the stronger its cash flow and the better it may be for the lender. Banks and other lenders would be looking for a DSCR of 1.25 or greater when considering loan applications.
Calculating DSCR
Understanding Terms
Debt Service
Debt service is the amount of money required to cover all loan payments for a given time period. It is called such from the term “servicing a debt” meaning to make all the payments on it.
A business with a single unsecured business loan with repayments of £3,140 per month would have a total annual debt service of £37,680.
Should that business also have asset finance for a car lease totalling £320 per month, the total annual debt service would be £41,520 (the £37,680 for the loan, plus £3,840 for the car lease).
Some debt may be more difficult to calculate, for example, lines of credit such as credit cards that do not have a fixed repayment schedule. In some cases, it is enough to consider interest repayments alone, while other accounts will have a minimum repayment schedule that should be used to calculate debt service.
Net Operating Income (NOI)
Net Operating Income (NOI) is the total derived by calculating all income and subtracting your business operating expenses, not including taxes and debt payments.
Operating expenses include:
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Employee salaries
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Property rent
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Utility expenses
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Insurance premiums
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Cost of goods for sale
Net operating income is typically considered the same as Earnings Before Interest and Tax (EBIT) and some financiers will use EBIT in preference.
Determining Period
DSCR is a fluctuating value that will change as income ebbs and flows, debts are repaid, and new debts are acquired. For this reason, it is essential to see DSCR as a transient figure, recalculated on a regular basis.
Monthly DSCR, therefore, is a more up-to-date figure than annual DSCR, however, it is also more susceptible to changes over time.
When reporting your DSCR, it is important to clearly state the period it covers.
DSCR When Applying for a Loan
Usually, lenders will want to see a complete DSCR value that takes into account the additional debt service of the proposed loan. This means you should include any potential repayments into your DSCR calculation and not just provide a DSCR based on current obligations.
It is sometimes beneficial to provide “before” and “after” DSCR figures to paint a clear picture of the business as it is today, and how it would be affected with the proposed additional loan.
One mistake it is essential to avoid is that of calculating a DSCR that only considers the new loan and doesn’t include current obligations. This is a meaningless value that has no benefit to the lender or your business.
The DSCR Calculation
DSCR is simply calculated as NOI divided by Debt Service.
A DSCR
A DSCR of exactly 1 shows a business with zero cash flow, barely keeping its head above water, though not sinking. Again, this business is unsuitable to take on further borrowings.
A DSCR between 1.01 and 1.25 indicates a business that could take on more debt, with available cash flow to do so, however, it would be a higher risk for the lender.
A DSCR between 1.26 and 2 indicates a healthy business capable of servicing additional debt.
A DSCR >2 shows a business in a strong position.
Example
A company with an annual net operating income of £240,000 and an annual debt service of £165,000 would have a DCSR calculated as follows:
240,000 / 165,000 = 1.45 DSCR
That same company might fluctuate on a month-by-month basis, with their May figures representing a monthly NOI of £21,500 and the debt service of £13,750. In that particular month, DCSR would be calculated as follows:
21,500 / 13,750 = 1.56 DSCR
During the winter months, however, business is low. Thus in November with a lower income of only £14,800, DSCR would change as follows:
This would indicate that their ability to repay the loan during the spring and summer is far stronger than during the winter; many lenders may err on the side of conservative caution, considering the November low DSCR with more credibility than the stronger May figure.
Interest Coverage Ratio (ICR) vs. DSCR
One alternative to the more standard DSCR is the Interest Coverage Ratio (ICR). This is calculated in a similar way to DSCR however, rather than using a complete Debt Service calculation, it concentrates instead on the interest-only portion of any debts.
ICR shows a company’s financial stability when it is not repaying the principal on its loans. This is a preferable metric to use when debt is made up of interest-only loans, for example, in many property management businesses.
ICR will return a far more lenient figure than DSCR in those cases and may be the more relevant coverage ratio to use.
Other Coverage Ratios
There are two other coverage ratios that are sometimes of interest to lenders and may be taken into consideration when looking for commercial financing.
These are:
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Asset Coverage Ratio (ACR) - This measures the business's ability to cover its debt service by liquidating its owned assets.
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Cash Coverage Ratio (CCR) - This measures the business's ability to cover its debt service using only cash immediately available.
While these other coverage ratios exist for the purposes of understanding the business, DSCR is always the more relevant figure.
The Debt Service Reserve Account (DSRA)
If the business DSCR is on the low side of a lender’s threshold, they may still consider finance if the business is prepared to create a Debt Service Reserve Account (DSRA).
This is a specified cash reserve that is put aside to act as a buffer and service debt should any problems occur. Typically, it would represent six months or a full year of calculated debt service.
Should the debt be defaulted and the DSRA utilised, the additional breathing room it represents would allow refinancing to be discussed and suitable financial management to be put in place.
DSCR Loan Pros and Cons
Using DSCR as a basis for loan suitability rather than credit history or other methods has both advantages and disadvantages to businesses.
Pros of DSCR Loans
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Higher loan-to-value (LTV) - Loans based on DSCR calculations are seen as less risky by lenders, especially if the DSCR threshold is relatively high. This enables lenders to comfortably lend larger amounts, especially when considering asset-based loans.
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Flexibility - DSCR loans are calculated independently to more traditional credit score based loans, allowing businesses with poorer credit status to access sizeable loans. Additionally, DSCR loans look solely at the business credentials and are less likely to require personal guarantees.
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Lower interest - With the increased security, many DSCR-based loans are set at a lower rate of interest than comparable credit score loans.
Cons of DSCR Loans
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Income required - Obtaining a DSCR loan is dependent on showing regular sustained income. This tends to make them unsuitable for startups or businesses that cannot prove reliable turnover.
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Strong financial position - The DSCR calculation is not to be taken lightly. Businesses looking to use DSCR to facilitate a loan need to have fluid cash flow that is larger than the projected debt service.
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Business acumen - Lenders are likely to want to see experience in the business before agreeing to a DSCR-based loan. This means documents like the business plan and demonstrable industry experience are important factors.
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DSRA - Many lenders will insist on a DSRA (Debt Service Reserve Account) before agreeing to a loan.
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Reliability - DSCR calculations can be complicated and mistakes can be made. Not only that but changes month-on-month can see even the most stringently calculated DSCR fluctuate. Both businesses and lenders need to understand the transient nature of DSCR values.
Obtaining a DSCR Loan with Clifton Private Finance
Our business loan experts offer a complimentary advice service and can help you choose the right finance solution for your business requirements. They have access to a wide range of finance solutions from across the market.
Our specialist team can help you to source the most competitive DSCR loan.
Our business loan service provides:
- Market-leading rates
- Fast service - finance within 2 to 7 days
- Access to specialist lenders
- Expert advice - professional service
Call us on 0117 332 5583 to discuss your requirements.
Or you can book a free consultation with one of our expert advisers at a convenient time for you below.
FAQs
How Do I Calculate DSCR?
DSCR is calculated as Net Operating Income (NOI) divided by Debt Service. A full explanation on these terms and how to calculate DSCR forms part of this article above.
Is DSCR Important?
While some lenders will not consider DSCR, especially when looking at traditional business loans that use credit scoring to determine risk, more lenders are looking to DSCR to provide an important metric in underwriting loans.
Even if you are not looking for a DSCR loan, paying attention to your DSCR and debt service is worthwhile.
What is a Good DSCR Score?
A DSCR above 1 indicates that the business can meet its debt obligations, and the greater the number the better.
Most lenders would want to see a DSCR of 1.25 or greater, showing that you have the cash flow required to pay all your debts (including the prospective new debt) with room to manoeuvre.
Is a DSCR Loan or a Traditional Business Loan Better?
A lot depends on the status of your business and where you are in your growth trajectory. DSCR-based loans provide many benefits but they are not always the best way to obtain funding.
Speaking to a qualified advisor will help in determining the right loan for your business.
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