Insights · Underwriting

Debt service coverage: how lenders compute it and where a file usually fails

Certus Credit · 9 November 2026 · 5 min read

Most lenders want debt service coverage of 1.25 times or better: $1.25 of cash for every dollar of principal and interest due in the year. The number that matters is not the one the owner computes from the P&L. It is the one the lender computes after three adjustments the owner usually did not make.

The formula, and the three versions of it

Debt service coverage is cash available for debt service divided by the year's debt service. The denominator is simple enough: every scheduled principal and interest payment on every loan, including the one being applied for. The numerator is where lenders differ, and the difference is the whole story.

A bank starts with earnings before interest, taxes, depreciation and amortization, then takes off cash taxes, the capital spending the business cannot avoid, and any money the owners took out. What is left is what could have paid the debt. Most banks want that number at 1.25 times debt service on the last full year, and they will look at the trailing twelve months as well.

An SBA lender works the same way but the floor is 1.15 times, set in the program's rules, and the test is run on the historical numbers and on the projection. Below 1.15 the loan does not get approved however good the collateral is.

A private credit lender or an asset-based lender usually writes the test as a fixed charge coverage covenant, often 1.10 or 1.20 times, measured every quarter on a trailing basis, with the same deductions. Pass it and nothing happens. Fail it and the agreement gives the lender rights it did not have the day before.

For loans under about $2M, and for most SBA loans, there is a fourth version: global coverage, which adds the owner's personal income and personal debt to the business numbers. Above that size the business is expected to carry the debt on its own.

The three adjustments

The owner's version of the ratio is EBITDA over debt service. The lender's version takes three things off the top.

Distributions. If the company is an S corporation or an LLC, the owner's draws are not on the P&L, so the owner's ratio ignores them. The lender reads the K-1 and the bank statements and takes every dollar that went to the owner as if it were an expense, because next year it will leave the business again.

Unfinanced capital spending. Depreciation was added back to get to EBITDA, but a machine shop still buys tooling and replaces a spindle every year with cash. The lender takes the three-year average of what was spent and not financed, and deducts it.

Add-backs. The owner's EBITDA often includes adjustments: a legal settlement called one-time, a salary called excess, a bad year called an anomaly. The lender accepts the ones that are documented and will not recur, and rejects the rest. A settlement that shows up two years running is not one-time.

Two more things happen on the denominator. A line of credit that the owner counts at its interest cost may be counted at interest plus a share of principal, because some lenders assume a revolver that never comes down is really a term loan. And any short-term debt with daily or weekly payments is counted at its full annual cost, not the balance.

A $6M manufacturer, both ways

Take a contract machining business with $6M of revenue and $900,000 of EBITDA, applying for a new term loan to buy out a partner. The numbers are illustrative.

Debt today: a $1.9M bank term loan at 8.25 percent over seven years, about $358,000 a year in principal and interest. A $650,000 equipment note at 7.9 percent over five years, about $158,000 a year. A $1.15M line of credit at 9 percent, $103,500 a year in interest. Debt service is roughly $619,000.

The owner's math: $900,000 over $619,000 is 1.45 times. Comfortable.

The lender's math starts in the same place and makes the adjustments. Unfinanced capital spending averaged $70,000 a year over the last three years. Distributions to the owner, on top of salary, were $100,000. Cash available for debt service is $730,000, and $730,000 over $619,000 is 1.18 times. Below 1.25. The bank passes, or offers a smaller loan than the buyout needs.

Nothing in the business changed between those two paragraphs. The file did.

What moves it back

Two changes close the gap, and both are structural rather than operational.

The equipment note is on a five-year schedule because that is what the dealer offered. Folding it into the term loan at the same rate over seven years makes the combined balance $2.55M and the payment about $481,000 a year. Debt service falls to $584,000, and $730,000 over $584,000 is 1.25 times. The loan now passes, at the line.

The distributions are the other lever. If the owner takes $40,000 next year instead of $100,000, cash available rises to $790,000. Over the restructured debt service of $584,000 that is 1.35 times, with room for a soft quarter. Over the original $619,000 it is 1.28 times, which also passes.

Done together, the two changes turn a decline into an approval with headroom, and the business made the same parts for the same customers throughout. Lenders are not grading the shop. They are grading the arithmetic, and the arithmetic can be set before the file goes out.

Where files fail

In our experience the failures cluster in four places. The owner's number was used, and the lender's adjustments came as a surprise after the first decline. The new loan's own payment was left out of the denominator, so the ratio that was pitched was the ratio before the loan existed. A one-time add-back was presented without the invoice or the court filing that proved it. And the line of credit was counted as interest only when the lender counted it as term debt.

Each of those is fixable before the first lender sees the file, and none of them is fixable after the third one has passed. Lenders talk to each other less than owners fear, but a file that has been declined twice reads differently the third time.

Running it on your own numbers

The exercise above takes an afternoon with the last three years of statements, the tax returns, the K-1s, the loan statements and the bank statements. Compute debt service on every position including the one you want. Take EBITDA, deduct what the owners took out, deduct the unfinanced capital spending, strip any add-back you cannot prove with a document, and divide.

If the answer is above 1.25, the question becomes which lenders fit the situation. If it is below, the work is in the structure, and that is where a debt advisor earns the engagement. The enquiry at certuscredit.com/apply asks about the business, the debt and the objective. We will tell you plainly where the coverage sits and what moves it.