Can you service the loan? DSCR and covenants in plain English

When you apply for a loan, someone at the bank runs a single number before anything else. Not your revenue, not your profit, not your credit score. They compute how much cash your business generates against how much it must pay out in debt service, and the ratio between those two decides most of the conversation.

It is called the debt service coverage ratio, and the useful thing about it is that there is no mystery to it. You can calculate your own in five minutes, know roughly what you will be told before you walk in, and fix it in advance if the answer is bad.

The ratio itself

DSCR is cash available to service debt divided by the debt service you owe. The numerator is usually EBITDA — earnings before interest, taxes, depreciation and amortization — because that approximates cash generated by operations. The denominator is all principal and interest due over the same period, including loans you already have.

Principal is the part people forget, and it is the part that matters. Your P&L only shows interest, so a business that looks comfortably profitable can have a DSCR under 1.0 once the principal repayments on existing debt are counted.

Where lenders will disagree with your math

Your DSCR and the bank's will differ, and it is worth knowing why before you are surprised by it:

• Owner's compensation. If you pay yourself well above market, a lender may add part of it back as discretionary. If you pay yourself nothing, they will subtract a market wage — and that adjustment sinks a lot of applications.
• One-time items. Genuinely non-recurring costs can be added back, but you have to make the case and document it. "Unusual" three years running is not unusual.
• Maintenance capital spending. EBITDA ignores capex, but trucks and equipment must actually be replaced. A careful lender subtracts what you need to spend just to keep running.
• Personal guarantees. For most small business loans your own finances are part of the analysis, and a global DSCR blends business and personal obligations together.

Covenants: the part in the agreement nobody reads

Getting the loan is not the end of the ratio. Most commercial agreements require you to maintain certain financial conditions for the life of the loan, tested quarterly or annually. These are covenants, and they are enforceable.

The common ones are a minimum DSCR, often the same 1.25x; a maximum debt-to-equity or leverage ratio; a minimum current ratio; and sometimes a cap on capital spending or on distributions to owners. There are usually reporting covenants too — financial statements delivered within thirty or forty-five days of period end.

Breaching one is technically an event of default even if you have never missed a payment. In practice a bank rarely calls the loan over a single breach; they issue a waiver, often for a fee, and sometimes reprice. But the leverage shifts entirely to them at that moment, and it tends to happen precisely when you have the least ability to negotiate.

Manage it forward, not backward

The mistake is treating covenants as an annual compliance exercise. If you find out in February that you missed a December test, the year is over and you cannot fix it.

Instead, calculate your covenant ratios every month using a rolling twelve-month window, and watch the trend rather than the level. You will usually see a breach coming two or three quarters out, which is enough time to do something about it — defer a capital purchase, hold off on a distribution, accelerate collections, or simply call the bank early.

That last one is genuinely underrated. A lender told in advance that a covenant will be tight, with an explanation and a plan, responds very differently than one who discovers it from a statement four months later. The ratio matters, but so does being the borrower who saw it coming.