Why Do Banks Focus So Much on Debt Service Coverage?
- Alana Gage
- Jun 3
- 2 min read
Debt service coverage is the most important metric banks use to qualify a loan, yet few people understand what it means. The Debt Service Coverage Ratio (DSCR) is a calculation which estimates how much free cash a farm generated on average over the past three, four, or five years to ensure a borrower can make all their payments on time. Lenders usually use the highest of these three numbers, which is why it's always beneficial to provide your lender more information rather than less.
To calculate DSCR, a bank first figures out your Earnings Before Interest, Taxes, Amortization, and Depreciation (EBITDA) and adds in any equipment or vehicle lease payments. At Glengarry, we call this EBITDAR, where the “R” stands for equipment rent. Then, the lender adds up all your debt payments (principal, interest, and lease payments) and divides the EBITDAR by the total debt payments.
A DSCR of 1.2 (120%) or higher is acceptable, and anything over 1.4 (140%) is considered good.
Example:
Let’s say a farm has:
Net income: $100,000
Amortization: $150,000
Equipment leases: $200,000
Interest costs: $50,000
The EBITDAR is $500,000 (adding all these together).
The Debt Service Costs are:
Lease payments: $200,000
Interest costs: $50,000
Principal payments: $100,000
The total Debt Service Cost is $350,000
.
To get the DSCR, you divide the EBITDAR ($500,000) by the debt service costs ($350,000), which gives a DSCR of 1.43 or 143%. This is a good result, and the farmer is likely to qualify for more financing, assuming there are no other issues.
A small complication comes with interest on revolving debt. The interest from lines of credit is included in both the EBITDAR and debt service cost calculations. If a farmer has $25,000 in revolving debt interest, both the EBITDAR and debt service costs will increase by that amount. However, the principal portion of revolving debt is assumed to be redrawn and doesn’t affect the calculation.
Many farmers struggle to get new loans because their DSCR is too low. At Glengarry, we help clients restructure and refinance their debts to manage this problem. If you’re experiencing roadblocks at your financial institution, connect with a member of our team today to ensure you have a backup plan. Reach us at JGinquiry@glengarry.ca.
