Business lenders use three key debt ratios to assess whether you can repay a loan — even if your business hits a rough patch. Each ratio measures a different aspect of your risk as a borrower.
- Debt service coverage ratio (DSCR): Measures your ability to cover monthly payments from cash flow
- Debt to Equity Ratio (DTE): Measures how much of your business’s total value is already financed by business loans or other debt
- Current Ratio (also called working capital ratio): Measures the amount of current assets versus your current liabilities
By knowing how to calculate these ratios and what they mean, you’ll be able to make the adjustments needed to achieve a better ratio. With better numbers, you’ll increase your creditworthiness and your chances of getting approved—and at better rates—for financing like a small business loan or a business line of credit.
Here’s what each ratio measures, where to find the numbers to calculate it, and prompts to use if you’d rather leverage large language models (LLMs) including ChatGPT, Perplexity, and Claude to calculate the ratio for you.
Debt Service Coverage Ratio (DSCR)
The debt service coverage ratio (DSCR) measures whether a business generates enough cash flow to cover its debt obligations, like working capital loans or business lines of credit, including both principal and interest payments. Here is how to calculate your DSCR:
- DSCR = (Net income + taxes paid + interest expense + depreciation and amortization) / Yearly debt principal and interest (P&I) payments.
Use your income statement to plug in the figures from above.
Note: The top part of the equation is a company’s earnings before interest, taxes, depreciation, and amortization (EBITDA = Net income + taxes paid + interest expense + depreciation and amortization). Some accounting software will automatically do the EBITDA calculation for you.
For the bottom part of the formula, add up your total monthly debt payments across all business loans, business credit cards, lines of credit, and other forms of debt. Then multiply by 12 to get the yearly sum. Then divide the top by the bottom number to get your DSCR.
A DSCR under 1.0 means you don’t bring in enough cash to pay your current debts, and future lenders likely won’t approve you for a loan without a solid plan for growth or collateral. Higher DSCRs are generally better because they show you have an extra buffer that can help sustain your business during economic downturns.
A good rule of thumb is to have a DSCR of at least 1.25 to 1.5. This ratio means your business has enough of a cushion to cover debt payments in case an economic decline occurs. Different lenders will have their own requirements for minimum debt service coverage ratios, so you can either shop around to find one that works with yours or you can use a financial marketplace like SBL to match you with the financing providers most likely to fund you based on your profile.
DSCR Ratio Prompt for AI
“Calculate my debt service coverage ratio with the following numbers:
- Net Income: XXX
- Tax & Interest Expense: XXX
- Depreciation: XXX
- Amortization: XXX
- Monthly total of all debt payments: XXX
First, walk me through the debt service coverage ratio step by step. Next, calculate each part of the formula individually. Then calculate my total DSCR and double check your work to make sure it is accurate.”
Note: It’s best to put this prompt into 2 different AI models, like ChatGPT, Gemini, or Claude, and compare their answers since AI tools can make mistakes.
Debt-to-Equity (DTE) Ratio
The debt to equity (DTE) ratio measures the percent of your company’s value that is funded by debt compared to the amount funded by equity, where equity is the amount owned by you and other investors.
Lenders use your debt-to-equity ratio to measure how much of the company is already funded by other lenders to see how risk you are as a borrower right now. From their perspective, they want to gauge how likely they’ll be able to recoup their investment if you default and they have to sell your assets/collateral. It also shows lenders whether you have skin in the game and how motivated you may be to keep your business up and running. For example, a high debt to equity ratio means you only own a small percentage of the company, so you may not be as motivated as someone who owns a larger percentage of their company and is applying for the same loan. This formula is what lenders use to calculate your DTE ratio. You can find these numbers on your balance sheet:
- DTE = Total Debt / Total Owner’s Equity
Lenders might refer to this ratio as your leverage ratio. Let’s say you have $500,000 in debt and $50,000 in equity. That makes you highly leveraged with a DTE of 10 ($500K/$50K) and a high-risk borrower. Like DSCRs, check with a few lenders on their specific requirements for DTE.
AI Prompt to Calculate DTE
“Attached is a copy of my current balance sheet.
- My total debt is: $XY
- My total equity is: $XZ
Calculate my debt-to-equity ratio, share the steps you took, and then double check your work to make sure it is accurate.”
Note: Remember to use 2 different AI services to double check for accuracy.
Current (Working Capital) Ratio
The current ratio (also called “working capital” ratio) measures your current assets versus current liabilities (current means within 1 year). It tells lenders whether your business can meet short-term obligations without taking on more debt.
Lenders will look extra closely at this ratio when considering whether to provide short-term business loans like inventory financing or business bridge loans. This is the formula used for the current (working capital) ratio:
- Current Ratio = Current Assets / Current Liabilities
All of the numbers you need are on your balance sheet, and most accounting software automatically calculates the total of current assets and liabilities for you. You can also ask your accountant for the numbers.
Having a current ratio under 1 means you’re in immediate danger of a cash shortage because you owe more in the next year than you have available to pay off your debts. Higher ratios like 1.25 to 1.5 are better in general to show you aren’t a near-term default risk.
Note: If you have a lot of inventory but little cash, then aim for a ratio of 2, in case lenders want to discount the inventory to adjust for risk of it becoming obsolete.
Suppliers will also want to see your current ratio before giving you credit terms like net-30/60/90 because they want to be confident that you’ll still pay them back if you’re not able to sell all of what you buy from them.
Prompt for AI to Get Your Current Ratio (Working Capital Ratio)
You can upload your balance sheet or combine this with the DTE prompt above since the numbers come from the same balance sheet:
“Attached is a copy of my current balance sheet and I need you to use the numbers from it to calculate my working capital ratio, which is also known as a current ratio.
- Calculate total current assets, which is found in <insert location>.
- Calculate total current liabilities, which is found in <insert location>.
Please calculate my current ratio, list the steps you used, and explain your reasoning for each — I want to verify you used the correct numbers. Double-check your calculations once you’re done.”
Lenders use all three ratios together to determine how creditworthy you will be as a borrower. DSCR is used to make sure you’ll cover monthly payments even if sales fall a bit, the DTE helps make sure you don’t have too many other lenders already funding your business, and the current ratio is there to build confidence that you have enough assets to operate and cover debts for the next year.
SmallBusinessLoans does not provide tax, legal or accounting advice. This material has been prepared for informational purposes only. You should consult your own tax, legal and accounting advisors.
