As a small business owner, you may have asked yourself: “What exactly is Debt Service Coverage Ratio? How will it impact on my loan application?” For the uninitiated or those who may be applying for a business loan for the first time, this term, Debt Service Coverage Ratio, may sound strange and unfamiliar. For others who are mostly fixated on interest rates and monthly payments commonly associated with loans, the term may hold a vague meaning and significance. In either case, it’s good to know what it is and how it works especially for business owners and entrepreneurs.
What is Debt Service Coverage Ratio?
In essence, a Debt Service Coverage Ratio is a yardstick, a sort of a measurement index that lenders use to help them determine if a business owner is in a position to take on a loan. Note, however, that this is only one of the many factors banks and financial institutions take into consideration in assessing whether or not a Loan application deserves approval.
There are two types of Debt Service Coverage Ratio
These two types are Gross Debt Service Coverage ratio (GDS) and Total Debt Service ratio (TDS). Both are used as a preliminary assessment to find out if you are already in debt and if so, how deeply are you in it. In other words, your lender has to know the risks involved in providing you a loan and if you’ve got the capability to make the payments.
- Gross Debt Service Coverage ratio (GDS) – This type involves calculating all your monthly costs specifically related to housing such as mortgage, association fees, security and trash collection fees (if you’re living in a private gated residential subdivision), etc. and then relating this to your monthly gross income to get an idea on the extent of your obligations relative to the money that comes in. The specific formula works this way:
Total monthly housing costs /gross monthly income x 100 = GDS ratio
Example (using hypothetical numbers)
$6000/$20000 x 100 = 30% GDS ratio
Traditionally, a GDS ratio of below 30% is regarded favorably by most loan providers as it indicates you’re not overwhelmed with debts. A few percentage points above 30% raise a red flag, as it suggests too many expenses at the moment to safely borrow from a lending firm. Even so, as stated in the previous paragraphs, this GDS ratio is only one of the many considerations in the loan evaluating the process. The income growth potential of your profession or proof of exponential sales and revenues of a business owner could also come into play. So will your Business credit score.
- Total Debt Service ratio (TDS) – This is the other kind of Debt Service Coverage Ratio. It’s essentially the same as your GDS except this one involves calculating all your monthly expenses (not only those related to housing). This will include your monthly car loan payments, credit cards (both business and personal), alimony and any other loan payments. The formula to calculate your TDS ratio goes this way:
Total monthly debt payments/monthly gross income x 100 = TDS ratio
Example (using hypothetical numbers)
$10000/$36000 x 100 = 27.7% TDS ratio.
In regard to TDS, to properly qualify for a loan your ratio should be below 40%. Ergo, in the example above the TDS ratio of 27.7% will be looked on by money lending groups to be very favorable, as it shows you are managing your debts well and are in a position to receive another loan.
If you’re a small business owner or an entrepreneur contemplating a start-up enterprise that may need some good funding, calculating both your GDS and TDS ratios should give you an idea about the chances you’ve got to successfully get loan approval.