What is the Debt Service Coverage Ratio (DSCR)?
Definition: The debt service coverage ratio (DSCR) is a metric that assesses the ability of the company to pay off its current debts relative to net income. The financial ratio measures if the company can generate adequate profit to meet its debt obligations. Usually, lenders and banks could use this metric to determine the suitability of awarding a company a loan. In essence, this is a comparison of the firm’s available cash relative to the principal, current interest as well as sinking fund commitments.
The ratio applies if the business has credit lines or loans to its debt. Equally a company can employ the ratio to assets its ability to cover for its debts. For instance, if a company is considering taking debt to shore up growth but wants to determine if it is in a position to take another debt with the risk they can use the DSCR.
Considering the DSCR is used to determine the company’s ability to pay off its debt it becomes an important metric for creditors and investors. Creditors will be interested in the company’s cash flows and cash position as well as the amount of debt it owes. The ratio becomes important in knowing how much cash the company has available to service its current and yet to be incurred debt.
Interestingly unlike debt ratio, DSCR considers all expenses linked to debt such as interest expenses, sinking fund commitments as well as other commitments like a pension. As a result, it is a more accurate way of determining the ability of the company to meet its debt commitments relative to the debt ratio.
Debt Service Coverage Ratio Formula
To calculate the DSCR formula, one needs the entity’s debt service as well as disposable operating income.
To get net operating income:
(excluding interest payments and taxes). It is sometimes taken as the company’s EBIT and you can obtain this from the income statement of the company
Equally, total debt facility is an equivalent of the company’s debt obligations which include sinking- fund, principal and interest payments as well as other commitments expected in the following year. Although this amount is not included in financial statements it is most of the time included in notes.
Sometimes income taxes can complicate the calculation of DSCR since interest payments count as tax deductibles whereas principal payment doesn’t. Therefore the best way to determine total debt facility is through:
Debt Service Coverage Ratio Example
The ratio is important to companies because it helps them asset their ability to keep debt at current levels. Therefore a high ratio is preferable by the company relative to a low ratio because it shows that the company has more available income to service its debt. Interestingly if the debt ratio of a company is 1 then it implies that its net operating income and debt service commitments are equal. This means that the company is generating enough income for paying off its debt.
On the other hand, if the ratio is below one the company is not generating adequate profits to meet its debt obligations and it has to dig deep into savings.
This measure is important for lenders who use it in assessing the company’s DSCR before approving a loan. Therefore is the ratio is below one then it implies the company will not be able to cover its current debt commitments without digging to other sources like borrowing more. This is a put off for lenders but sometimes a lender could consider if the company has other resources besides income.
Some lenders might require the business to keep a minimum ratio when there is an outstanding loan. However the minimum ratio a lender demand depends on the macroeconomic environment in that if there is growth credit is easily available and lenders can compromise for lower ratios.
Debt Service Coverage Ratio DSCR Calculator
Here is a DSCR calculator, so you can easily compute your own DSCR problems.
DSCR Excel Template
Here is a DSCR excel template that you can use to calculate the debt service coverage ratio for your business.
