In this fourth posting about the financial ratios that help businesses understand how they can do more, we cover a Debt Service Ratio and what it means. A Debt Service ratio is one of the five ratios contained in our FREE Business Health Check that we provide to SME businesses that are looking for opportunities to improve.
A Debt Service Ratio tells a bank or lender (as well as a business owner) how much cash or income is being used to cover interest payments due on liabilities of the business. The formula for a Debt Service Ratio is:
Debt Service Ratio = Net Operating Revenue / Interest payments
If the result of a Debt Service Ratio for a business is less than 1 it means that a business is not generating enough revenue to pay for its interest payments. Most SME businesses will rely on its owners to inject equity into the business to make up for the deficiencies in servicing its debt obligations. Quite frequently we see business owners leverage their personal net worth through mortgages and loans and then use the cash as a shareholder loan to the business.
Conversely, a business that has a Debt Service Ratio of more than 1 means that it is generating enough revenue to pay for its interest payments. Banks and lenders like to see a Debt Service Ratio of more than 1.25 and often times will use up to 3 years of financial history to average out the Debt Service Ratio.
We have one ratio left to cover that will round out our review of the 5 financial ratios contained in our FREE Business Health Check. The last ratio is called a Debt to Equity Ratio and can be the most important ratio for a business to know.