How to calculate debt-service, with examples

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In this lesson, I'm going to give you a live example of how to calculate your debt service coverage ratio. A couple of things before we get to it, I know that this is most likely going to be the longest video in the entire series. That's because I have detailed pieces to the example that I want to go over with you. So if you feel lost if it's too much information, if you need to look at the information again, don't hesitate to pause, or stop and come back and watch this episode or this lesson. Again, it's going to be fairly detailed, but that's important because I'd like for you to show up with your lender conversations armed with what your debt service coverage ratio is, or at least close to what it is, so that you can have a deep conversation with the lenders that you're talking to.

Now, also note that I may pause to catch my own breath, maybe grab some water to wet my voice or something like that, but know that I'm still still here with you. Okay, let's get It. So just a reminder, in the last lesson, we talked about the top three, the big three criteria that all lenders look for in a loan application. And I made it really clear that debt service coverage ratio is always the primary source of repayment. And, as a reminder, it is essentially a fancy word for how much money is coming in versus how much money is going out. Remember, when we go through the example that what a lender is going to be looking for is a 1.25 ratio or higher.

That means that for every $1 and quarter of income coming in that there's no more than $1 going out, and that includes your new loan payment. So you're going to want to factor that into your calculations as well. All right, for this example, I'm going to use the simplest tax return that there is because tax returns are going to be provided to the lenders and that is what they will use To calculate your debt service coverage ratio, this is merely an example tax return. And in this example, instead of using a business tax return, I am using your individual tax return, we will take a look at multiple examples. So this is a 1040 or an individual tax return. And the reason I'm using this one is assuming in this instance that you are a sole proprietor that you are in business under your social security number, and the business shows up on your schedule C on your tax return.

So a couple things on the 1040. to note on line seven is where your day job income will come in, or if you paid yourself as an employee through another company income will come in there. In this instance, I have a simple number plugged in of $60,000. Then further down, I want you to take a look at what is called line 12, which is where your business tax return your business income or loss We'll come through and if you'll see there it says attached Schedule C or C EZ, which is just your easy Schedule C for smaller businesses. But the line 12 if you see a number there on your income or someone else's that you're looking at means they are have a business that is ran as a sole proprietor. And that income is then moved from the Schedule C to the front page of the tax return.

Another common place we're going to be looking when we talk to lenders for income or or actually losses is on line 17, which is if you own rental real estate, or maybe you own an S corp, or something like that, those incomes and losses will flow through those places as well. And then the final line to look at is line 22, which is just a summary of all of the items before seven through 21. And it gets to the total amount of income that you have. Now, let's continue with the example. This is the second page of a 1040 tax return. So you can see On line 38 was the summary of the income that $60,000.

And this instance on line 40 are your living expenses and lenders will use this number. These are essentially also called from accountants perspective, your itemized deductions, and they are the things that will reduce your taxable income. In this instance, lenders will use that number as your living expenses. Or they may also use a number that is a percentage of your income. So they may take 60,000 as your income and assume that you have 10 or 20% of your income tied up in living expenses. And then they take that percentage and deduct that from your income to get to line 41, which would be your total amount of income after living expenses in this example, we're not using percentage, we're just using the itemized deductions.

So we go from 60,000 minus 10,007 59. 48 49,241 All right, then in line 42, you have some additional numbers that the lenders most likely will use, and this is additional deductions. And then you get to line 43, which is your taxable income. Line 44 shows the taxes that you paid and that number is 4481. And that will be deducted because you do have to pay taxes to get to your total amount of income. All right.

So, the other thing to understand when you're calculating your debt server, debt service coverage ratio is that you have some items that can be added back to your income to get to a larger number, assuming you have them. On this page, we have a schedule a which is often the third page in your tax return. And the key number here that lenders look for is that item that is on line 15, which is mortgage interest. This is interest you've paid on Any mortgage for a home that you have, and that will be added back to your income to give you a large number. And the reason this is added back is because when we get to the part where they're calculating your debt payments that you have that show up on your personal credit, since mortgage interest is already built into the monthly payment that you make on your mortgage loan, that's why it is added back.

So it's important to note that this number can be added back to that 49,241 to get you to a larger amount of income, because we're going to end up taking that interest back anyways, when we do your loan payments. That's the first of two add backs. So here's the full example of everything I just said. So you've got your 60,000 as your net income. And again, just remember this is for simplicity sake, then take away your $10,759 in living expenses that was online. 40 take away your 40 $400 and 81 8040 $481.

That was for taxes, and then add back your 50 $200 in mortgage interest, and that would get you to it to a total income that could be used toward your debt service coverage ratio of 49,960. Got it? All right. Again, be sure to pause or rewind if you need to take a look at that again. Now, here's some personal income that may not be counted for a variety of reasons. Let's take a look at them.

Line eight on the same front page of your 1040 personal tax return is where interest comes in. This is interest maybe you were paid on a savings account to a bank. Line nine is dividends. Maybe you were paid dividends for stock that you own. In some instances these will not be counted towards your personal life. Come unless you can prove that you are getting those paid to you on a regular multiple year basis.

And the reason it is is perhaps the stock that was paying you a dividend, you sold it and you no longer have it. Or perhaps the interest that you have from a bank was for a CD that you had and you no longer have it. Some lenders will immediately take these out of your personal income and not count them. If they do that. It's because they don't they consider them what's called a one time income. Okay?

Also something else that may not be counted is capital gains on line 13. Or even in some instances, capital losses. This is when you sell investments and you either gain money or lose money on the sell of those investments. Since you sold them you're only get a one time gain from them. So many lenders will remove that from your personal income numbers. And then finally, any unemployment comp compensation that you had during the year.

Though that will also often be removed from your personal income, because the lender is hoping you're not going to be unemployed again in the future, and therefore, it's a one time income. All right, here is an example now of a business return, this is going to look a lot different than the personal return. But again, we're going to take the income from the personal side, the income from the business side, put both of those together together to get a total amount of income that can count towards your debt service coverage ratio. So line one is the gross revenue of the business. Now where I see a lot of entrepreneurs make a mistake, if they haven't existing business with business tax return is they tell the lender that their total amount of income out of the business in this instance is $453,000. That's just not true.

You have expenses you have to pay. So we're going to be looking at the net income $453,000 in gross revenue, the lender will then take your cost of goods sold co GS online to to get to that line three, which is your gross profit, that carries down to the gross income on line 11. And the reason that's a little bit bigger than the gross profit is because they had some interest, same kind of thing will happen with that interest. If the lender determines that's a one time interest payment, then that will be removed and they would only use the number on line three, which is $391,308. In this instance, we're going to assume it's not a one time payment. So you're regularly getting that interest and you can prove you're regularly getting that interest every year, we're using $391 624 $391,624.

Then you're gonna have all these other items on there that you have to consider. At the end of the day. The way this works is all those items line 12 all the way down until about line 26 are added together and the has your total deductions which are really your operating expenses are $342,738 Excuse me, we subtract that from the gross income online 11. And that will get us to $48,886 in net income. All right now, on that same page, there were a couple of things that I ignored. These are additional add backs from a business perspective that can be added back to your income to count toward your debt service coverage ratio.

Just like the mortgage interest on your personal tax return the interest online 18 is oftentimes interest may be that you're paying on a real estate loan or some other type of loan and that will be added back for the exact same reason that the mortgage interest was batted back with is because that interest is being taken away when we add in the payments so we have to add it back to keep from you getting double dipped on line 20 is depreciation of depreciation without going too far into it isn't accounting Soft dollar loss, it's not real money out of your pocket therefore it is added back in as well. And then finally, although not many companies have it in this example there is one line 20 is depletion. depletion is usually where you have the loss of natural resources like oil and gas. But these are all key add back to look for regardless of which line they're on based on the type of tax return you're have look for, in particular interest in depreciation and add those back to the income of the business to get a total amount that can count toward your debt service coverage ratio.

So, at the end of the day, for this example, on the business itself, we take line one, less line two, we get the gross income of 31 $391,308. We then add back line 18. Add back, excuse me, that should be line 20, not line one of 133,532 dollars in depreciation that gets us to line 12. We subtract that for the total amount of expenses. And then that's how we get to the actual debt service or them sorry, the actual income they can count for the business towards your debt service is the opposite of the total income of $48,570. Adding back the interest of $10,033 plus the depreciation of $133,533.

And in this instance, you would have $189,136 of income from the business to count for debt service coverage ratio. I'm going to go ahead and move past this because I went ahead and covered it. Just remember, interest may not be included because it can be considered a one time expense in many instances. So we have line one, minus line two gets us to line 11 And then total deductions gets us to 48,570. So, now we've looked at both a personal tax return and a business tax return. And so for this example, if that were the borrower, the $49,960 plus $189,136, it's a total amount of income to count towards your debt service coverage ratio of $239,096.

Alright, let's talk about personal debt expenses. So now that we've covered your income, we need to look at where your expenses are. personal debt expenses come off your credit report. And these are fixed payments that you have to make as an individual, and they are included for each owner of the company. So if there's two founders of the company, when we're calculating your debt service coverage ratio, then each person's credit will be pulled, and all of their debt payments would be added up to go toward the expense side of this calculation. They usually come off your credit report, but you may have to report them separately if they are not, then to make sure that you're reporting them appropriately, the lender will often match them against the second page of a personal financial statement, which goes into detail of your personal expenses and debts.

They include things like car loans, house payments, credit card payments, and more. Here's an example of a credit report and what this might look like. This can be a little tough to read, so don't get too stuck on it, but pause here if you want to dig into detail. As a reminder, credit reports generally come from one of three places which is Experian, TransUnion, and Equifax. Now, the way to read this is, and I've got the arrows pointing, you can see there's a real estate account, it's reporting the total balance of roughly 108 208 500 but it does consistently show the payment is 1300 and $20. That's going to be added To go toward your personal side, your personal expenses to counter your personal income on the debt service coverage ratio.

There's also a revolving account, otherwise typically known as a credit card payment of some sort or a line of credit. Notice in one instance, it's reported as 100. The other it's 110. I talked before about credit reports where there are slight variations, so that's okay, they're going to use the higher of the two. Sometimes they will use a percentage of the credit card balance, some lenders will have a rule where they use 3%, or some other ratio of the balance rather than what the what the minimum payment is listed at as which is $110. There's no delinquencies, which you can see I point out on here, which is good news for you as a borrower.

There's nothing derogatory, and there's the number of inquiries is also called out on this example. I share that with you because if you have had too many inquiries on your credit recently, a lender could get scared But from a personal expense perspective, we have 1400 and $30, which is the house payment plus the credit card at 110. And we get a total of $17,160 per year. Also, they're gonna add in your business debt expenses. These are also fixed payments that your business has to pay. And they are included for the company you have own and any company that others own.

So if there's two founders in your business, and the other founder owns another business, likely that debt will count toward your debt service coverage ratio, even though you are not an owner. These also come off of a business credit report I talked about that previously, review the lesson on credit reports. And they're matched against what's called a debt schedule. And the documentation section I talked about having to provide a debt schedule. It is just you listing every single debt that the business has, so the lender can make sure that They're calculating all those in. That includes equipment, loans, any payments to suppliers, those kinds of things.

So, let's take an example here. You want to borrow money to buy your building, it's $5,000 a month or $60,000 a year, you almost borrow. You also want to borrow some money for the some equipment, which is $3,000 and $36,000 a year and you've already made these have these debts, I apologize. So your total business debt expenses are $96,000 per year. Now, you may recall that your business debt expenses were 17,160, the mortgage payment in the credit card, you've got $96,000 in annual business expenses for the this building that you've already borrowed against, and the equipment that you've already borrowed against. And so your total debt expenses for the year are 113,160.

Now don't forget when we calculate debt service coverage ratio, We factor in the new loan that you're requesting, which is very important. So we're going to pretend that you've applied for a line of credit. And the payment on that is going to be $1,000 or $12,000 per year. Your personal expenses are 17,001 60, the business is 113,001 60. And your new business loan line of credit is 12,000. So we get to a total of 125,160.

Looks like my math is terrible, but let's roll with it. Total Income as a reminder when we did that exercise was $239,096. total expenses for personal and business was 125 160. So your debt service coverage ratio is that income divided by that expense total for 1.91 times or x which is higher than the typically typically required. minimum of a 1.25. In this instance, you're showing $1 and 91 cents for every dollar that's going out, which includes the new loan, which in most instances, as long as everything else looks okay, credit, liquidity, collateral, those types of things.

If you have a 1.91 times debt service coverage ratio, you're sitting in a very good position to get your loan approved. All right, let's do the exercise here. All numbers are annualized total income is what your personal income of the two owners is 48,000 for one and 24,000. For the other. The net business income is $35,000. You paid an interest of 5000 plus depreciation of 2000.

So your total income in this example will be 114,000. It's just the Addition of all of those numbers below to get to that number expenses using the the numbers below what are your total expenses? Well, you had some personal expenses were owner number one has a car loan and a house payment. Owner number two has a credit card and a car loan. The business has two existing loans one for a piece of equipment and one for a line of credit and it wants to borrow money for a building alone. What are the total expenses, hit pause and calculate it.

That's $140,000 400 $140,400 by adding all of those together. So your debt service coverage ratio in this example, is 114,000 in income divided by total expenses of 140,400 which means you are what we would call below a one to one or you are only only showing 81 cents of income for every dollar going out, which means every month or a year, you are losing ground, you're losing money. And in this instance, most likely, unless you can offer some significant collateral, or other mitigating factors, because your debt service coverage ratio is below these normal 1.25 times, most likely your line your loan request would be declined.

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