In this article we will review the debt coverage ratio and its importance when seeking financing for business growth.
Some business owners assume that growing sales equate to business growth, but that is not always the case. Analyzing your financial ratios, such as debt coverage ratio, will help you evaluate your business operation and determine if you are able to take on business debt.
What is debt coverage ratio?
Debt coverage ratio is a formula that compares cash flow to business debt. Stated another way, it’s a formula that shows how much cash flow you have available to pay your existing and future business debt obligations.
How do I calculate debt coverage ratio?
To calculate the debt coverage ratio, you need two variables to plug into the formula below:
- Cash flow is defined as the total annual cash flow generated by the business.
- Debt service is defined as the total annual debt payments the business must pay.
Debt Coverage Ratio = Cash Flow / Debt Service
How do I calculate cash flow?
To calculate your annual cash flow, turn to the Profit & Loss Statement (P&L) of your business tax returns (usually on the first page on the tax returns). Find the following numbers and simply add them up:
+ Profit before taxes
+ Depreciation (wear and tear of fixed assets)
+ Amortization (write-off of intangible assets over its expected period of use)
+ Interest payments
=TOTAL CASH FLOW
How do I calculate debt service?
To calculate your annual debt service, (1) you must add up your total monthly loan payments on existing debt, and (2) calculate your monthly loan payment on new debt. Then multiply by 12 (months in the year) to determine your annual payments:
+ Total monthly payments on existing debt x 12
+ Monthly payments on new debt x 12
=TOTAL DEBT SERVICE
Note: If you have business credit cards that are paid in full every month, do not add this payment amount to the “total monthly payments on existing debt.”
Why is debt coverage ratio important?
The debt coverage ratio measures whether your business can afford its debt obligations.
Without enough cash flow to pay the bills, your business runs the risk of defaulting on its debt. It also determines your ability to borrow money at more attractive interest rates. Higher risk means higher interest rates.
Different banks have different debt coverage ratio requirements. According to the Small Business Finance Institute, lenders typically require a minimum debt coverage ratio of 1.25. In other words, for every $1.00 of debt, the business has 25% more cash flow available to serve as a cushion. Debt coverage ratio is an important measurement lenders consider when evaluating a business loan.
As a community lender, Excelsior Growth Fund can be more flexible on debt coverage ratio requirements than a conventional lender. We can also help you improve your debt coverage ratio by reducing your existing monthly debt payments and increasing your cash flow through refinancing.
About Excelsior Growth Fund
Excelsior Growth Fund (EGF) helps businesses in New Jersey, New York and Pennsylvania grow by providing streamlined access to business loans and advisory services. EGF’s signature product, the EGF SmartLoan™, provides up to $100,000 in fast, transparent, and affordable financing through a secure online platform. Larger loans up to $500,000 are also available. EGF is a nonprofit organization and is certified by U.S. Department of Treasury as a Community Development Financial Institution (CDFI). Learn more atwww.excelsiorgrowthfund.org.