The Debt Service Coverage Ratio (DSCR) measures the power of a corporation to use it’s operating income to repay all its debt obligations, including repayment of principal and interest on both short-term and long-term debts. The ratio states net operating income as a multiple of debt obligations due within one year, including interest, principal, sinking-fund, and lease payments.
This ratio is usually used when a corporation has any borrowings on its record like bonds, loans, or lines of credit. It’s also a commonly used ratio during a buyouts transaction, to gauge the debt the capacity of the takeover target, alongside other credit metrics like total debt/EBITDA multiple, net debt/EBITDA multiple, interest coverage ratio, and glued charge coverage ratio. The ratio reflects the power to service debt given a specific level of income.
The minimum debt service coverage ratio a lender will demand depends on macroeconomic conditions. If the economy is growing, lenders could also be more forgiving of lower ratios.
There are two ways to calculate this ratio, both require net operating income and total debt service of the entity. Net operating income may be a company’s revenue, minus it’s operating expenses, not including taxes and interest payments. It’s often considered the equivalent of earnings before interest and tax (EBIT).
DSCR=EBIDTA/Interest+Principal
DSCR=EBIDTA-CAPEX/Interest+Principal
Where:
EBITDA = Earnings Before Interest, Tax, Depreciation, and Amortization
Principal = the entire loan amount of short-term and long-term borrowings Interest = the interest payable on any borrowings
Capex = cost
Some companies might like better to use the latter formula because the cost isn’t expensed on the earnings report, but rather considered as an “investment.” Excluding CAPEX from EBITDA will give the corporate a particular amount of operating income available for debt repayment.
Lenders will routinely assess a borrower’s debt service coverage ratio before making a loan. A DSCR of but 1 means negative income, which suggests that the borrower is going to be unable to hide or pay current debt obligations without drawing on outside sources – without, in essence, borrowing more.
Lenders frown upon negative income, but some allow it if the borrower has strong resources outside income. If the debt-service coverage ratio is just too on the brink of 1, say 1.1, the entity is vulnerable, and a minor decline in income could make it is unable to service its debt. Lenders may in some cases require that the borrower maintain a particular minimum DSCR while the loan is outstanding. Some agreements will consider a borrower who falls below that minimum to be in default. Typically, a debt service coverage ratio greater than 1, means the entity – whether an individual, company or government – has sufficient income to pay its current debt obligations.
A limitation of the interest coverage ratio is the incontrovertible fact that it doesn’t explicitly consider the power of the firm to repay its debts. Most long-term debt issues contain provisions for amortization with dollar sums involved like the interest requirement, and failure to satisfy the fund requirement. A ratio that attempts to live the repayment ability of a firm is the fixed cost coverage ratio.
