Debt service coverage ratio (DSCR) is a ratio used by lenders to assess a company’s capacity to pay off current interest and installments. Lenders often judge a company’s creditworthiness through this ratio. The ratio tells whether or not a company has free cash available from its operations to cover all the debt payments. In this blog, we discuss the relevance and formula of Debt Service Coverage Ratio.
Keynote: The debt service coverage ratio is used to check the debt absorption capacity of a borrower.
The formula of Debt Service Coverage Ratio
Typically, DSCR is determined when a company takes out a financial loan from a bank, financial institution, or any other loan provider. This ratio is calculated to find out the capacity of cash profits available with the borrowing company to cover the repayment of the proposed loan (in addition to existing ones) and interest thereof on a timely basis. It compares earnings with all the likely loan obligations (whether long-term or short-term).
The formula for computing DSCR is as follows:
In this formula, net operating income is adjusted for any non-cash items and is then divided by debt payments. It is preferable to use adjusted earnings since they are a close representation of the free cash flows available with a company. It is only the free cash flows that can accurately predict a company’s ability to meet its debt obligations. Therefore, adjusted earnings are computed as follows:
Earning for debt service* = Net profit (Earning after taxes) + Non-cash operating expenses like depreciation and other amortizations + Interest + Other adjustments like a loss on sale of Fixed Assets, etc.
For the denominator, the constituents of debt payments in this formula primarily include interest obligations which are expected to mature in the coming one year, a short-term debt payable, any fixed deposits or loans maturing in one year, and the current installment portion of long-term debt.
Nature of output
A debt service coverage ratio is always expressed in terms of a number. For example, 1.25 DSCR would mean that there is $1.25 of free cash flows available for every $1 of debt payments.
Let’s take another example. Suppose a retail trader is seeking to obtain a business loan from a local bank. The lending bank will want to compute the DSCR to measure the ability of the trader to borrow and pay off their loan as the retail sales they make generate money.
The trader estimates that net operating income will be $1,150,000 per year, and the bank notes that the annual debt service costs will be $250,000. The DSCR is computed as 4.6, which should mean the borrower can meet their debt payments more than four times given their operating cash flows.
What is the ideal ratio?
Normally, a debt service coverage ratio of 2 is considered satisfactory by lenders and financial institutions. This provides comfort to the lenders that there will be sufficient cash to meet debt service commitments, even in the event when net operating income falls a little less than projected. (source)
The greater the DSCR, the better is the debt servicing capacity of the borrowing company and the more are the lenders assured that the company’s profits can handle any uncertain changes in interest rates or other economic factors.
But, a moderate ratio may not always be bad, especially for growing companies. A growing company would constantly require debt for its business needs. The company may not use all its proceeds to repay its debt obligations but rather plough it back to enhance its business. This is especially true for companies who are still in their growing stage than their counterparts. Hence, there may be a need for constant debt in such companies and hence, a low DSCR may not always have an unfavorable impact on the lenders. What matters the most is the ability of a company to replace its existing debt with fresh funds and the financial flexibility that it has to access funds (both from the equity or debt market). Such access can be influenced by factors such as low gearing, a strong business model, strong operating cash flows, etc.
A ratio less than 1 indicates that a company would not be able to service all its immediate debt obligations likely to arise in the coming year. It signifies negative cash flows and thus, creates a need to borrow more in order to pay off existing debt.
For example, a DSCR of 0.85 means the net operating income is sufficient to cover only 85% of annual debt payments.
Interpretation of DSCR
The ratio is a significant metric used by lenders to determine a borrower’s ability to service the loan in terms of timely interest payments and repayment of loan installments.
If the debt service coverage ratio is too close to 1, the organization is susceptible to risk, and even a little drop in its cash flows could cause it to default on its loan. That is why lenders normally demand the borrower to maintain a specified minimum DSCR (based on macroeconomic conditions) while the loan is outstanding.
Rather than focusing on a single metric, it is better to analyze how a company’s debt service coverage ratio compares to that of other companies in the same industry. When a company’s debt service coverage ratio (DSCR) is much higher than the majority of its competitors, it signals superior debt management. A financial analyst may also wish to look at a company’s ratio over time to determine if it’s improving (increasing) or deteriorating (getting worse).
DSCR vs. ICR
To assess the coverage of loan payments, another commonly used measure that you must have seen is the interest coverage ratio (ICR). The interest coverage ratio shows how many times a company’s operational profit will cover the interest it must pay on all of its obligations over a specific time period. However, the debt service coverage ratio is a little more comprehensive. The DSCR is a more powerful indicator of a company’s financial health because it takes into account, not only interest but principal payments also. This ratio reveals whether the company is profitable enough to pay not only the interest expense but also the principal amount owed.
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