What Is The Debt Service Coverage Ratio? (How To Calculate)

By Indeed Editorial Team

Published 15 October 2022

The Indeed Editorial Team comprises a diverse and talented team of writers, researchers and subject matter experts equipped with Indeed's data and insights to deliver useful tips to help guide your career journey.

Companies often borrow money from lenders, banks and investors to expand their business and increase revenue. Lenders usually prefer calculating the debt service coverage ratio (DSCR), which assesses a company's financial health to decide whether to approve the loan. Understanding how to calculate the DSCR can help you secure financing for business expansion. In this article, we define what DSCR is, outline its importance, use and advantages, explore the formula, review how to interpret it, discover steps for calculating it and review an example.

What Is The Debt Service Coverage Ratio?

The debt service coverage ratio is a debt ratio that measures a company's ability to make dividend payments, repay its outstanding loans and take on new financing. This ratio compares the company's available operating cash flows to its debts. It is a ratio used by banks and financial institutions to determine the sustainability of debt. DSCR determines the maximum loan a lender offers for commercial and real estate financing. In addition, DSCR finds many usages in corporate and personal finance situations.

In corporate finance, DSCR shows a company's ability to pay its debt, while in personal finance, DSCR helps a bank determine the interest rate. Typically, banks, financial institutions and lenders prefer a higher DSCR because it shows that the company has sufficient funds to service its debt obligations and can make required payments promptly.

Related: What Is A Liquidity Ratio? (Definition, Types And Example)

Why Is The Debt Service Coverage Ratio Important?

The DSCR ratio determines the financial health of a company. A lower ratio shows that the company has a higher chance of defaulting payments. To understand a company's financial health, a financial analyst compares it with other companies operating in the same industry. Comparing the DSCR ratio of an airline company, which uses larger debts, with a software company, which uses minimum debt and more equity financing, is inappropriate because both companies have different debt structures.

What Is The Use Of DSCR?

There are three primary purposes of using the DSCR, including:

  • Investment: Shareholders and investors use the DSCR to know the financial health of a company and its ability to pay dividends to the shareholders. It helps determine how much the company has to pay its investors and shareholders.

  • Loans: Lenders and creditors use the DSCR to measure a company's ability to pay its interest and principal amount on outstanding loans. It helps banks and financial institutions decide the risk associated with lending to a particular company.

  • Strategic planning: A company evaluates their capacity to grow and obtain additional financing. It might be beneficial to calculate this ratio when an analyst performs financial forecasting for a major investment or part of strategic planning.

Related: What Is Financial Modelling? (With Benefits And Types)

Advantages Of DSCR

A lender might ask for the DSCR figures of the previous year or for up to three years to understand the company's financial stability. Here are a few advantages of using DSCR:

  • Identifies the position of a company from one period to another

  • Helps analyse how the company might perform relative to its competitors

  • Allows lenders to decide the likelihood of a borrower making a monthly loan payment

  • Helps in analysing a company's income cushion that can cover fluctuations in cash flow while making principal payments

  • Increases the chances of earning a lower interest rate and high borrowing amount

  • Shows a business has a positive cash flow

Formula For Calculating DSCR

Here is a formula for calculating the DSCR:

DSCR = Net operating income / Total debt service

In this formula, total debt service is the current debt obligations, which includes any interest, sinking funds and principal due in the upcoming year. Often, you calculate the current debt obligations by adding principal loan payments and the loan's interest. You might see EBITDA – CAPEX instead of net operating income in the income statement. EBITDA is the earning before interest, tax, depreciation and amortisation, whereas CAPEX is a capital expenditure. Both terms provide the same value. The other DSCR formula is:

DSCR = (EBIDTA – CAPEX) / (Principal + Interest)

Components of the DSCR formula using EBIDTA – CAPEX

Here are the additional formulas involved in calculating the components of this formula:

  • EBIDTA = Net income + Interest expense + Taxes + Depreciation + Amortisation

  • CAPEX = Change in property, equipment and plant + Current depreciation

Related: What Is Asset Turnover Ratio? (With Formula And Example)

Interpreting The DSCR

After calculating the ratio, you can compare it with the number 1 to make assessments. Here is what the differing values can mean:

When DSCR is less than one

A DSCR of less than one implies that the borrower cannot cover the debt payments. This means the business has negative cash flow, which might prevent a lender from giving a loan. The borrower can get a loan only if they show that they have another way of getting cash flow outside the business. For instance, if the DSCR is 0.68, the borrower has sufficient net income to pay 68% of their debt and requires an additional 22% of funds to cover the remaining debt payments.

Related: What Are Profitability Ratios? (With Types And Examples)

When the DSCR is equal to one

If the DSCR is equal to one, the borrower has cash flows to pay their debt. In addition, such a business or company might be vulnerable to risk because any loss of a significant customer causes the business to have negative cash flow and might result in them not paying the debt. Typically, in such cases, the bank or lender requires a borrower to have a specific DSCR for the loan's duration.

Related: What Is Working Capital Management? (Importance And Ratios)

When the DSCR is greater than one

A DSCR greater than one means the company has enough cash flow to cover its debt payments. Every loan is unique and has a minimum DSCR, but most lenders prefer a DSCR between 1.2 to 1.4. Typically, a ratio of two or above is an ideal ratio.

How To Calculate The DSCR?

Use these steps to calculate the DSCR:

1. Calculate the net operating income

Depending on the company's finances, you can calculate the net operating income in several ways. Find the net operating income by considering a company's gross profit and subtracting it from the operating expenses. For larger corporations, you might consider the earnings before interest, tax, depreciation and amortisation. The formula for calculating net operating income is:

Net operating income = Gross profit – Operating expenses

Related: Format Of A Cash Flow Statement (With Methods And Examples)

2. Determine the total debt service

The total debt service of a company includes the principal loan payment and the interest on a loan. For instance, if the principal loan payment for a loan is ₹5,00,000 and the interest on a loan is ₹50,000. The total debt service is ₹5,50,000. The formula for calculating total debt service is:

Total debt service = Interest payment + Principal payments

Related: What Is Debt Financing? (With Advantages And Disadvantages)

3. Calculate the DSCR ratio

Use the DSCR formula to calculate the resulting ratio. If the net operating income of a company is ₹5,00,000 and the total debt service is ₹4,00,000. The DSCR is:

DSCR = Net operating income / Total debt service

DSCR = ₹5,00,000 / 4,00,000 = 1.25

4. Evaluate the meaning of DSCR

Typically, a ratio of above 1 is ideal because it shows a company's ability to pay its debt and loans. In the example, the DSCR is 1.25. This means that the company has enough income to cover its debts.

Example Of Calculating DSCR

Here is an example of calculating DSCR:

Sumit Paper is a paper manufacturing company that ships paper around the world. Over a few years, the business has witnessed tremendous growth and is planning expansion. The company is planning to increase its manufacturing capabilities to increase production. The gross profit of Sumit Paper is ₹60,00,000 and the operating expense is ₹45,00,000, the principal loan payment of the existing loan is ₹13,00,000 and the interest expense is ₹1,00,000.

The accountant calculates the net operating income and the total debt service to know the DSCR.

Net operating income = Gross profit – Operating expenses
Net operating income = ₹60,00,000 – ₹45,00,000 = ₹15,00,000

Total debt service = Interest payment + Principal payments
Total debt service = ₹1,00,000 + ₹13,00,000 = ₹14,00,000

Now, calculate the DSCR.

DSCR = Net operating income / Total debt service
DSCR = ₹15,00,000 / ₹14,00,000 = 1.071

Sumit Paper has a DSCR of 1.071, just greater than one. This means the company has the sufficient cash flow to cover its debt payments. The DSCR of 1.071 means the company has 7% more income than debts. If Sumit Paper loses a prominent customer, the company might face challenges in repaying the loan on time. Based on DSCR calculation, lenders are likely to approve the loan at favourable terms.

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