Worked Examples and Checklists
Debt service coverage ratio (DSCR): a worked example for a Canadian business loan
How Canadian lenders calculate the debt service coverage ratio, a full worked example, how much you can borrow at a 1.25 minimum, and how to stress-test the result.
The debt service coverage ratio (DSCR) is the number most Canadian commercial lenders use to decide whether your business can afford a loan. It divides the cash the business generates in a year, before paying lenders, by all the loan payments due that year, principal and interest. A DSCR of 1.00 means every dollar of cash goes to lenders; most lenders want a cushion, and minimums around 1.20 to 1.50 are common, set by each lender and written into the loan as a covenant. Work out your DSCR before you apply, both on last year's results and on your forecast.
This guide is part of the business loan application checklist. All figures are illustrative.
The formula
DSCR = cash available for debt service / annual debt service
- Cash available for debt service usually starts with EBITDA (earnings before interest, taxes, depreciation and amortization), then subtracts cash taxes paid, and often owner draws or dividends and capital spending not financed by debt. Lenders' definitions differ; the covenant in your loan agreement is the definition that counts.
- Annual debt service is the total of principal and interest on all term debt for the year, including the new loan, existing loans, and often equipment lease payments and shareholder loan repayments.
A worked example
A Halifax print-and-sign shop wants a $250,000 loan over 7 years at an illustrative 8% to buy a wide-format printer and fit out a second location.
Step 1: cash available
| Item | Amount |
|---|---|
| EBITDA last fiscal year | $120,000 |
| Less cash income taxes paid | −$12,000 |
| Cash available for debt service | $108,000 |
Step 2: debt service
| Debt | Annual payments |
|---|---|
| Existing van loan and equipment lease | $24,000 |
| New loan: $250,000, 8%, 7 years (about $3,897 a month) | $46,759 |
| Total annual debt service | $70,759 |
Step 3: the ratio
DSCR = $108,000 / $70,759 = 1.53
At a lender minimum of 1.25, the request passes with some room.
How much could the shop borrow?
Turn the formula around to find the maximum.
- Maximum debt service at 1.25 = $108,000 / 1.25 = $86,400 a year.
- Less existing payments: $86,400 − $24,000 = $62,400 a year, or $5,200 a month, for the new loan.
- A payment of $5,200 a month at 8% over 7 years supports a loan of about $333,600. Over 10 years it would support about $428,600.
This explains why a longer amortization can make a loan approvable, and why a larger loan can fail. A $400,000 request over 7 years would mean about $74,814 a year of new payments and a DSCR of $108,000 / $98,814 = 1.09, below most lenders' minimums.
Stress-testing the result
Lenders look at what happens if things go wrong. Do the same:
| Scenario | Cash available | Debt service | DSCR |
|---|---|---|---|
| Base case | $108,000 | $70,759 | 1.53 |
| Floating rate rises to 10% | $108,000 | $73,804 | 1.46 |
| EBITDA falls 20% (taxes fall in proportion) | $86,400 | $70,759 | 1.22 |
A 20% drop in earnings would push the ratio just under a 1.25 covenant. That would be a breach even though every payment was made. See covenant breach and default for what that means, and consider asking for a covenant tested annually on a trailing basis, or set at 1.20, if your earnings are seasonal or volatile.
Common adjustments lenders make
- Owner compensation. In a corporation, a lender may add back owner salaries above a market level, or subtract dividends paid. In a sole proprietorship, the lender will subtract a reasonable living draw.
- One-off items. A lender may add back a clearly one-time expense, such as a move, if documented, and remove one-time income such as a government subsidy.
- Unfinanced capital spending. If the business must spend each year to keep equipment working, some lenders subtract it.
- Leases. Under accounting standards some businesses use, leases appear as debt; under others they appear as rent. Ask how the lender treats yours.
- Interest-only periods. If a loan has a period without principal payments, the lender may test DSCR on the full payment that follows.
How to improve a weak DSCR
- Borrow less, or fund more of the project from cash.
- Lengthen the amortization, which lowers annual payments, at the price of more total interest.
- Refinance expensive existing debt first; see refinancing an expensive business loan.
- Lease some equipment if the lease payment is lower than a loan payment would be; see equipment lease versus loan.
- Show the forecast: if the loan finances something that adds cash flow, a credible forecast can support a request that last year's numbers would not.
- Clean up the statements: work with your accountant so one-off items are clearly identified.
Use the payment calculator to test different amounts and terms quickly.
Frequently asked questions
Is DSCR the same as interest coverage?
No. Interest coverage divides earnings by interest only. DSCR includes principal, so it is stricter and more useful for amortizing loans.
Which year does the lender use?
Usually the last completed fiscal year, with year-to-date results and your forecast as support. Covenants are then tested on each year-end, or on a rolling 12-month basis.
What minimum DSCR should I expect?
It varies by lender, sector and loan type. Ask the lender for the number and its exact definition before you accept.
Does the CSBFP or BDC use DSCR?
Lenders under the CSBFP and BDC assess repayment capacity too, and DSCR is a common way to measure it, but each lender applies its own policy.
Sources
- BDC — guidance on cash flow, ratios and loan applications
- Innovation, Science and Economic Development Canada — CSBFP lending rules
- CPA Canada — financial statement standards and finding an accountant
