What is the debt service coverage ratio?

A financial statistic called the Debt Service Coverage statistic (DSCR) assesses the connection between a business’s operating income and its debt commitments, which include principal and interest payments. It serves as a gauge of a company’s financial health and ability to repay debt by showing how much of its cash flow can be used to meet such obligations. 

Debt service is the amount of money required to pay both the interest and principal on a mortgage or other debt over a set period of time. The term can refer to personal debt, such as a mortgage or a student loan, as well as corporate or government debt, such as corporation loans and debt-based instruments like bonds.

Calculation of DSCR:

The DSCR is calculated by dividing a company’s net operating income (NOI) by its total debt service (TDS). The formula for DSCR is as follows:         

 𝐷𝑆𝐶𝑅=𝑁𝑒𝑡 𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝐼𝑛𝑐𝑜𝑚𝑒/𝑇𝑜𝑡𝑎𝑙 𝐷𝑒𝑏𝑡 𝑆𝑒𝑟𝑣𝑖𝑐𝑒

• Net Operating Income (NOI) stands for the business’s earnings before taxes, interest, and depreciation., and amortization (EBITDA) or earnings before interest and taxes (EBIT).
• Total Debt Service (TDS) includes all payments for debt, including principal, interest, and leasing payments. 

Advantages

• This allows one to compare the operational performance of different businesses.
• Compared to other financial ratios, it includes more financial categories, such as principle repayments.
• It often use a rolling annual calculation method, which may provide a more complete picture of a company’s financial status.

Disadvantages

• A company’s finances may only be partially incorporated if some costs (such as taxes) are removed.
• Heavily relies on accounting norms, which may not appropriately indicate when cash is required.
• It is more hard to calculate than other financial indicators.
• Treatment and standards vary widely among lenders.

Why is it important?

DSCR is a frequently utilized figure in loan contract talks between enterprises and banks. For example, a qualifying corporation seeking a line of credit may require a minimum DSCR of 1.25. In this instance, it is possible to conclude that the borrower has fallen behind on their repayment. DSCRs can help analysts and investors evaluate a company’s financial strength while also assisting banks in risk management.