2 min read
The debt-service coverage ratio
The debt-service coverage ratio (DSCR) is the central affordability metric in commercial lending. It is calculated by dividing the company's annual net operating income or EBITDA (earnings before interest, tax, depreciation, and amortisation) by its total annual debt-service obligations — principal and interest — across all facilities, including the proposed new loan. A ratio of 1.0x means the business generates exactly enough cash to cover its debt obligations; below 1.0x, it cannot service its debt from trading alone.
Most commercial lenders require a minimum DSCR of 1.25x to 1.5x, providing a buffer against revenue fluctuations. The required minimum rises for riskier sectors, earlier-stage businesses, or where security is thin. Some lenders test DSCR using net profit rather than EBITDA, which produces a more conservative figure because it deducts depreciation as a proxy for capital maintenance requirements.
Stress testing the assessment
A static affordability calculation at current trading is not sufficient for most lenders. Underwriters typically apply stresses — reductions in revenue, increases in costs, or rises in interest rates — to test whether the business remains solvent under adverse conditions. For variable-rate facilities, interest rate stress of two to three percentage points above the base rate is common.
Revenue stress scenarios are calibrated to the sector. A hospitality business might be stressed by a 30% revenue reduction; a professional services firm with long-term contracts might be stressed by only 10–15%. The goal is not to predict the worst case precisely but to ensure the business has sufficient headroom to absorb a plausible adverse scenario without triggering a covenant breach or default.
Free cash flow versus EBITDA
For capital-intensive businesses, EBITDA can overstate available cash because it adds back depreciation without accounting for the ongoing capital expenditure required to maintain the asset base. Lenders in manufacturing, logistics, and similar sectors frequently use free cash flow — operating cash flow after maintenance capex — as their preferred affordability metric. Businesses in these sectors should prepare cash flow statements that separately identify maintenance and growth capex to give the lender a clear picture.
Existing obligations and covenant headroom
A lender assesses affordability not just for the proposed facility but for the full existing debt stack. Hire-purchase agreements, finance leases, invoice finance facilities, and other borrowings all create annual cash obligations that reduce available DSCR headroom. Directors should prepare a complete schedule of existing financial commitments before applying, including residual values on leases and the monthly cost of any CBILS or Recovery Loan Scheme facilities still in repayment.
Frequently asked questions
Do director drawings affect the affordability assessment?
Yes, particularly for owner-managed businesses. Lenders examine whether director salaries and dividends are commercial and sustainable. Unusually high drawings relative to profit can indicate that reported EBITDA is artificially elevated, and the lender may normalise the figure before running its DSCR calculation.
Funding for UK limited companies
Credicorp lends to your company, not to you personally — short-term working capital with no personal guarantee. See what your business could access.