Do you want a high or low cash coverage ratio?
The higher your cash coverage ratio, the better the financial condition your business is in. But how do you know when you should be concerned? Any time that your cash coverage ratio drops below 2 can signal financial issues, while a drop below 1 means your business is in danger of defaulting on its debts.
The general rule is that the higher the ratio, the better position a company has to repay its interest obligations while lower ratios point to financial instability. Analysts generally look for ratios of at least two (2) while three (3) or more is preferred.
As a general rule, however, a DSCR above 1.25 is often considered “strong,” whereas ratios below 1.00 could indicate that the company is facing financial difficulties.
In most industries, the example above would be a prime example of a good cash flow coverage ratio. Generally, businesses aim for a minimum of 1.5 to comfortably pay debt with operating cash flows.
A cash debt coverage ratio of 1 or higher implies that the business is liquid enough to clear its debts on time. Similarly, a low net cash flow from operating activities resulting in a cash debt coverage ratio of less than 1 indicates low liquidity.
Generally, a higher coverage ratio is better, although the ideal ratio may vary by industry.
Intuitively, a lower ratio indicates that less operating profits are available to meet interest payments and that the company is more vulnerable to volatile interest rates. Therefore, a higher interest coverage ratio indicates stronger financial health – the company is more capable of meeting interest obligations.
If the DSCR is 1.2, that means the property can cover its total debt 1.2 times over the current year. This is assuming that the debt obligations do not increase. Naturally, a DSCR of less than 1 is not as reassuring for lenders.
A ratio of 2 or higher is generally seen to be healthy. “If you're at 1, all of the EBITDA you earn is going straight to debt,” Sood says.
The DSCR is calculated by dividing the operating income by the total amount of debt service due. A higher DSCR indicates that an entity has a greater ability to service its debts. Banks and lenders often use a minimum DSCR ratio as a condition in the covenant, and a breach can sometimes be considered an act of default.
What is the best coverage ratio?
Overall, an interest coverage ratio of at least two is the minimum acceptable amount. In most cases, investors and analysts will look for interest coverage ratios of at least three, which indicate that the business's revenues are reliable and consistent.
Conversely, a ratio lower than 1.0 shows that the business is generating less money than it needs to cover its liabilities and that refinancing or restructuring its operations could be an option to increase cash flow. In some cases, other versions of the ratio may be used for other debt types.
Lenders generally want to see a DSCR of 1.25 or higher — meaning if you have a $1,000 in debt obligation, you'll need $1,250 in net operating income to qualify for a loan. A DSCR of less than one is a red flag for small business lenders.
Anything less than 1x (or 1:1) is considered very weak and suggests that a company owes more money to creditors (per year) than it generates in cash per year. Most commercial banks and equipment finance firms want to see a minimum of 1.25x but strongly prefer something closer to 2x or more.
A debt ratio between 30% and 36% is also considered good. It's when you're approaching 40% that you have to be very, very vigilant. With a threshold like that, you're a greater risk to lenders. You may already be having trouble making your payments each month.
Interpreting the Debt Ratio
If the ratio is below 1, the company has more assets than debt. Broadly speaking, ratios of 60% (0.6) or more are considered high, while ratios of 40% (0.4) or less are considered low.
As a general benchmark, an interest coverage ratio of 1.5 is considered the minimum acceptable ratio. An ICR below 1.5 may signal default risk and the refusal of lenders to lend more money to the company.
The minimum DSCR requirements vary by lender and depend on several conditions, including the economy. If credit is more readily available, lenders may accept lower ratios. However, most lenders look for a DSCR of at least 1, but ratio requirements of 1.25 to 1.5 are the most common.
Lenders generally want to see a DSCR of 1.25 or higher — meaning if you have a $1,000 in debt obligation, you'll need $1,250 in net operating income to qualify for a loan. A DSCR of less than one is a red flag for small business lenders.
DSCR > 2: When a company's DSCR is above 2 then the company is able to cover at least double its debt obligation amount. A high DSCR ratio suggests a healthy cash flow operation and a low debt risk profile.
What does a DSCR of 0.5 mean?
Conversely, a ratio below 1 is not a good sign because it means that the company is unable to service its current debt commitments. For example, if a company has a DSCR of 0.5, then it is able to cover only 50% of its total debt commitments.
The higher the ratio is above 1, the better. In this example, the company has a DSCR of 1.5, which means it should have enough income to cover its debt. Ratios can be used any time you're trying to reach a goal, and they're everywhere in business.
In most cases, a lender will look for a minimum DSCR of at least 1.15, which indicates that based on current net operating income, the business would be able to repay any loan with interest.
An entity with a lower DSCR is generally considered a higher risk, more likely to default on its debts. Conversely, an entity with a high DSCR is generally viewed as a more favorable candidate with less risk of loan default.
Down payment: DSCR loans typically require a down payment of 20-25% of the purchase price. However, some lenders may offer lower down payment options to borrowers with strong credit and experience with investment properties.
