How to compute debt service coverage, step by step

What the ratio asks

Divide the cash the business generates in a year by the debt payments it owes in that year. Above 1.0 means operations cover the payments. Below 1.0 means something else is covering them.

The arithmetic is trivial. Every fight is about what goes in the numerator and what counts as debt service in the denominator, so do it the way an underwriter would and you will not be surprised by their answer.

Step one: build the numerator

Start with net income from the tax return or year-end accounts, then add back the non-cash and financing items already subtracted from it.

Illustrative only — net income $84,000, depreciation and amortisation $16,000, interest expense $12,400. That gives $112,400 of cash available for debt service.

Add back only what is genuinely non-cash or genuinely discretionary, and expect to defend each one. Owner compensation above a market salary is a common add-back and a common argument. A one-off legal settlement is usually allowed. Depreciation is allowed and then quietly resented, because equipment does wear out.

Do not add back principal repayments you have already made. They are in the denominator, and counting them twice is the most frequent error on a self-prepared calculation.

Step two: build the denominator

Every scheduled payment of principal and interest for the next twelve months, on every facility, including the one you are applying for.

Continuing the illustration: an existing term loan at $1,050 a month, an equipment lease at $780, and card minimums at $400. That is $2,230 a month, or $26,760 a year.

The new request is $150,000 over 60 months at a 9.5% nominal rate. The payment is $3,150.28, so $37,803.36 a year.

Total annual debt service: $64,563.36.

Step three: divide

$112,400 / $64,563.36 = 1.74.

That leaves $47,836.64 of cash after debt service, which is the figure the ratio is really standing in for. A ratio is a compact way of saying "there is room". The dollars say how much.

Most commercial credit policies set a floor somewhere at or above 1.15 to 1.25 and will tell you theirs if you ask. Nobody is obliged to publish it, and the floor is not the whole test — a business at 1.9 with one customer at 70% of revenue is a harder credit than a business at 1.35 with two hundred customers.

Step four: run it backwards

The useful version of this calculation is the one that tells you what you can carry, not what you already do.

At a 1.25 minimum, the maximum total debt service this business can support is $112,400 / 1.25 = $89,920 a year. Subtract the existing $26,760 and $63,160 a year is available for new debt — $5,263.33 a month. At the same 9.5% over 60 months, that payment supports about $250,600 of principal.

That is the number to walk in with. It also tells you when to stop asking.

What a daily-remittance product does to it

Illustrative only — add an advance remitting $13,000 a month to the same business. Annual debt service rises to $220,563.36 and the ratio falls to 0.51.

A ratio of 0.51 means operations produce half the cash the obligations require. The gap comes out of payables, taxes or another advance. Nothing about the product is hidden here — the dollars were always going to be the dollars — but the ratio makes visible what a weekly payment amount does not.

Two notes on this. First, if the remittance flexes with deposits, the twelve-month figure is an estimate, so run it at the contractual rate rather than the hoped-for one. Second, a bank that later reviews your file will run this same calculation and see the same 0.51, which is one reason a short-term advance can make the next facility harder to get. See total cost of capital versus payment affordability.

The global ratio, which is the one most small deals actually fail

On a closely held business, plenty of credit policies do not stop at the entity. They compute a global coverage ratio that adds the owner's personal debt service and, in some policies, a living allowance to the denominator, and the owner's outside income to the numerator. The logic is that a sole owner who cannot pay their own mortgage will take money out of the business to do it.

Continuing the illustration: the business covers at 1.74. Add the owner's personal debt service of $2,150 a month — mortgage, car, cards — with no outside income to offset it, and the denominator rises to $90,363 a year. The global ratio is 1.24, which sits below several common 1.25 floors.

Nothing changed about the business. What changed is which debts the policy counts. If you are the only owner and your personal balance sheet is carrying anything substantial, run the global version before the lender does, and bring your spouse's income documentation if it helps you rather than waiting to be asked.

What to do when you fail the test

Three levers, in order of how much they actually move.

What does not work is arguing the numerator. Add-backs a lender will not accept are not add-backs, and a self-prepared calculation that inflates them costs you credibility on every other number in the file.

The version to keep on one page

1. Net income, plus depreciation and amortisation, plus interest, plus defensible one-offs. Call it cash available for debt service.
2. Twelve months of scheduled principal and interest on everything, including the new facility.
3. Divide. Write the leftover dollars beside the ratio.
4. Solve for the maximum payment your target ratio allows, then convert that payment into a loan amount at the rate and term on offer.

Use the worst twelve months you have, not the best. The calculators will do steps three and four; step one is judgement, and it is the step a lender will not accept on your word alone. Have the tax return, the interim statements and the debt schedule ready in the same file, because the ratio is only as credible as the numerator it came from.