What is DSCR?
DSCR stands for debt service coverage ratio. It answers one question: does this business make enough cash to pay its loans, with room to spare?
- Debt service is every loan repayment due in a year: interest and principal (the amount borrowed).
- Cash available for debt service is the cash profit left after running the business, before those repayments.
Divide the second by the first and you have the DSCR. At 1.0x the business earns exactly what it owes, with nothing left over. At 1.5x it earns 50% more than it owes.
In an acquisition, DSCR is the number that tells a lender, a seller and you whether the deal pays for itself from the target’s own cash flow, or quietly leans on your existing business.
How do you calculate DSCR?
- Start with EBITDA. Earnings before interest, tax, depreciation and amortisation: operating profit with non-cash and financing items stripped out.
- Adjust for add-backs. Add back one-off or owner-specific costs that won’t continue (a one-time legal bill, the owner’s personal car). Be strict here. Inflated add-backs are the most common way a DSCR looks better on paper than in real life.
- Subtract a market salary for whoever replaces the owner. If the seller worked in the business unpaid or underpaid, someone has to do that job after settlement.
- Subtract maintenance capex. Capital expenditure is spending on equipment and assets; maintenance capex is what you must spend just to stand still.
- Subtract tax (lenders differ on whether they do this; ask yours).
- Add up annual debt service across every loan: senior debt repayments plus seller note repayments.
- Divide step 5 by step 6.
Lenders commonly use their own version of this formula, so treat your number as an estimate until the lender has run theirs.
A worked DSCR example (illustrative)
Illustrative only. A target business sells for $1.5M. After add-backs, a manager’s salary, maintenance capex and tax, it produces $525k a year of cash available for debt service. Assume senior debt at 8% over 5 years and a seller note at 6% over 4 years. Here is how three ways of funding the same price change the DSCR:
| Funding mix | Senior debt | Seller note | Seller rollover | Annual debt service | DSCR |
|---|---|---|---|---|---|
| All bank debt | $1.5M | $0 | $0 | about $376k | about 1.40x |
| 70/20/10 | $1.05M | $300k | $150k | about $350k | about 1.50x |
| 60/40 | $900k | $0 | $600k | about $225k | about 2.33x |
Same business, same price, very different risk. The 60/40 has the strongest coverage because 40% of the price is seller rollover: the seller keeps a stake instead of being paid, so there is no repayment on that portion. The 70/20/10 lands at about 1.5x because the seller note is a loan that needs repaying, while the 10% rollover does not.
In practice, few lenders fund 100% of a price with debt alone, so the first row is there to show the maths, not a likely offer.
What DSCR do lenders want for a business acquisition?
Each lender sets its own minimum, often somewhere between 1.2x and 1.35x for an established business, and a covenant (a promise in the loan agreement) that you keep it above a floor every year. Industry, the quality of earnings and how much of the price is senior debt all shift the number.
A deal that just clears the lender’s minimum is a deal that breaks the first time a key customer leaves. That’s why we don’t design to the minimum.
Why does G&L structure deals at about 1.5x DSCR?
At around 1.5x, the acquired business earns roughly $1.50 for every $1 it owes. That buffer does three jobs:
- It protects your existing business. The new acquisition should carry its own debt. If it can’t, you’re funding it from your core profit, and you’ve bought a liability.
- It makes lenders comfortable. A comfortable lender is more likely to add a working-capital line, which is what makes a deal over-financed.
- It survives a bad year. Revenue dips, staff leave, a big customer renegotiates. At 1.5x, a 20% fall in cash flow still leaves you above 1.0x.
Josh Li bought two of his own clinics with 100% seller (vendor) finance, paid from each clinic’s cash flow. The lesson he carries into every structure: the seller’s repayments have to be affordable from the business itself, on a normal month, not a great one.
How does the deal structure change DSCR?
When a deal is funded, it usually draws on three parts:
- Senior debt (commercial debt): a loan from a lender, repaid first, usually with the fastest repayment schedule. It has the biggest effect on DSCR.
- Seller finance (vendor finance): the seller lends part of the price and is repaid over time. Longer terms and lower repayments help DSCR. See seller finance explained.
- Seller rollover: the seller keeps a minority stake instead of cash. No repayments, so it adds nothing to debt service. See seller rollover explained.
Moving value from senior debt to seller finance or seller rollover is the single most powerful lever on DSCR.
How can you improve DSCR on a deal?
- Shift part of the price into seller rollover. No repayments on that slice.
- Lengthen the seller note. Spreading $300k over five years instead of three cuts the annual repayment sharply.
- Add an interest-only or deferred start to the seller note for the first months while you settle in.
- Negotiate the price against verified cash flow, not the seller’s adjusted figures.
- Cut out the add-backs you can’t prove. A lower honest DSCR beats a high one that collapses in due diligence. Our due diligence red flags guide covers the add-backs that most often fall apart.
What happens if DSCR drops below the covenant?
A covenant breach doesn’t automatically mean the lender calls the loan, but it gives them the right to act. Typical responses are a waiver, tighter terms, extra reporting or a request for more security. Talk to your lender early: they react far better to a heads-up than to a surprise.
Want your deal structured at 1.5x?
On an acquisition strategy call we look at your business and your target market, and map the structure that keeps your first deal at around 1.5x DSCR. See if you qualify.