8 minute read

Debt-Service Coverage Ratio (DSCR) in Business Sales and Acquisitions

Debt service coverage ratio (DSCR) is a key metric when buying or selling a business, especially for buyers looking for acquisition financing. Both lenders and buyers use this financial ratio to assess whether a company’s income can adequately cover its current and future debt payments, including new acquisition loans. In this article, we’ll explain what DSCR is, why it matters in business transactions and financing, and how it impacts both business valuations and loan approvals.

Why DSCR Matters in Business Sales and Financing

As a business owner planning to sell, or a buyer seeking financing for an acquisition, understanding DSCR helps you determine if the business has sufficient income to cover existing and potential loans.

For buyers, a strong DSCR can mean the difference between loan approval and denial, or between favorable and costly financing terms. For sellers, demonstrating a healthy DSCR can attract more qualified buyers who can secure financing, potentially leading to a faster sale at a better price.

Key Stakeholders Who Use DSCR

• Buyers: Buyers rely on DSCR during due diligence to understand the business’s financial stability and ability to support acquisitions debt
• Sellers: By tracking and improving their DSCR, sellers can increase their business’s value and make it more financeable for potential buyers
• Valuators: People who assess a business’s worth use DSCR as a key metric to determine a company’s worth and debt capacity
• Lenders: Banks or financial institutions use DSCR to assess whether the buyer can handle both the acquisition debt and existing business obligations

Understanding DSCR Calculations

The DSCR formula is net operating income divided by total debt service.

Components of DSCR in Business Sale

When evaluating a business purchase or sale, two key components determine your DSCR. The first is Net Operating Income, which should reflect sustainable, recurring income from core operations. For small businesses, this often requires excluding one-time earnings and personal expenses that won't continue under new ownership.

The second component is Total Debt Service, which must include both existing business debt and any anticipated acquisition financing. This gives buyers and lenders a complete picture of the debt obligations the business will need to service after the sale. Understanding both components helps ensure accurate DSCR calculations for the transaction.

Common Variations of the Calculation

While the basic DSCR formula is most commonly used in business transactions, some situations call for variations. The Adjusted DSCR modifies net operating income to account for taxes and depreciation, providing a clearer view of actual cash flow. For acquisition planning, many buyers and lenders also consider Forward-Looking DSCR, which uses projected income and debt to estimate future debt service capability. This helps in understanding how the business might perform after the sale and with new financing in place.

What Makes a Good DSCR

Understanding what constitutes a "good" DSCR is important when buying or selling a business. While any ratio above 1.0 technically shows the business can cover its debt payments, most lenders and buyers look for stronger coverage. A DSCR of 1.25 is typically considered a strong benchmark, meaning the company generates $1.25 in income for every $1 in debt payments. Conversely, ratios below 1.0 indicate the business might struggle to meet its obligations.

However, acceptable DSCR levels can vary significantly based on several factors:

Type of Lender

Different financing sources have varying DSCR requirements:

• Commercial banks are typically most conservative, requiring 1.25 or higher for small business loans
• Small Business Administration (SBA) loans may accept ratios around 1.15, though they prefer 1.25 for comfortable coverage
• Alternative lenders might work with lower DSCRs, sometimes as low as 1.1, but often charge higher interest rates or require shorter terms

Business and Market Factors

Several other factors influence what's considered an acceptable DSCR:

• Business Size: Larger businesses typically need higher DSCRs (1.5+) to demonstrate stability, while smaller businesses or startups may face lower expectations
• Regional Economics: Areas with strong, stable economies might see more flexible DSCR requirements
• Industry Standards: Some industries naturally maintain higher or lower DSCRs based on their business models and risk profiles

DSCR for Business Buyers

Buyers use DSCR to assess whether a business generates enough income to cover its debts comfortably. A strong DSCR indicates financial stability and lowers acquisition risk.

Review Seller's DSCR Adjustments

• Carefully verify seller's financial adjustments:
  • Owner compensation normalization
  • Personal expense removals
  • One-time item exclusions
  • Facility cost adjustments
• Request documentation supporting each adjustment
• Identify any additional adjustments not captured by seller

Calculate Post-Acquisition DSCR

• Factor in all debt obligations:
  • Existing business debt service
  • Anticipated acquisition loan payments
  • Working capital lines of credit
  • Equipment financing or leases
• Use adjusted figures to calculate accurate post-purchase DSCR
• Consider different financing scenarios and their impact on DSCR

Use DSCR in Due Diligence and Negotiations

• Analyze historical DSCR trends for stability
• Compare industry standard DSCRs
• Use findings in price negotiations
• Include adjusted DSCR in loan applications
• Consider how different purchase prices and financing structures affect DSCR

Monitor and Address Common Challenges

• For seasonal businesses, analyze DSCR across full annual cycles
• Consider industry-specific factors like:
  • Equipment-intensive businesses needing higher initial DSCRs
  • Service businesses with variable revenue streams
  • Real estate components affecting debt structure
• Evaluate economic conditions impacting the business
• Assess any personal guarantees required for financing

DSCR in Loan Applications

When applying for acquisition financing, lenders focus heavily on DSCR as a key indicator of repayment ability. Most traditional lenders look for a minimum DSCR of 1.25, though some loan types may accept ratios as low as 1.15 depending on other business factors and industry standards.

To evaluate your loan application, lenders typically require:

• Income statements
• Cash flow projections
• Debt schedules
• Supporting documentation for any DSCR adjustments

If your DSCR falls below lender requirements, don't give up immediately. Be prepared to explain any temporary factors affecting the ratio, such as one-time expenses or seasonal fluctuations. You may also strengthen your application by providing additional financial metrics like cash flow forecasts, liquidity ratios, or strong credit history. Some lenders may be willing to work with lower DSCRs if you can demonstrate strong business fundamentals and a clear plan for improvement.

DSCR for Business Sellers

For sellers, a strong DSCR boosts business value, making it more attractive to buyers and supporting a higher price.

Prepare and Document DSCR Adjustments

• Identify and document standard financial adjustments:
  • Owner's salary and benefits adjustments to market rates
  • Personal and family expenses removal
  • One-time revenues or expenses exclusion
  • Facility rent adjustments to market rates (if owner-occupied)
• Maintain clear records showing:
  • Original and adjusted figures
  • Explanation for each adjustment
  • Supporting documentation
• Present both original and adjusted DSCR calculations in sales materials

Improve DSCR Before Listing

Short-Term Improvements:

• Optimize pricing and revenue streams
• Reduce unnecessary expenses
• Renegotiate debt terms where possible
• Clean up financial statements to minimize adjustments

Long-Term Strategic Improvements:

• Focus on high-margin products or services
• Build sustainable growth patterns
• Maintain healthy debt levels
• Implement strong financial controls

Monitor and Track Performance

• Set up systems to track DSCR monthly
• Address seasonal fluctuations proactively
• Document improvement trends
• Keep clear records of all changes
• Use strong DSCR to justify asking price
• Prepare transparent financial packages for buyer due diligence

Industry-Specific Considerations

Different industries require unique approaches when assessing DSCR. In retail and service businesses, seasonal fluctuations in cash flow mean annual income averages often provide a more accurate picture than monthly figures. Manufacturing businesses typically need higher DSCRs due to substantial equipment financing and capital requirements, reflecting the higher costs and revenue fluctuations common in this industry. For businesses with significant real estate components, DSCR calculations must consider whether properties are owned or leased, as well as factors like rental income and occupancy rates if applicable.

Remember that while sellers and buyers look at the same adjustments, their perspectives differ. Sellers focus on presenting an accurate, documented picture of the business's debt service capability, while buyers need to verify these adjustments and understand how they affect post-acquisition financing and operations.

Visit BizBuySell’s Finance Center to get more information on financing your small business acquisition. Or, learn more about financing your acquisition on our Learning Center.

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