What Is Debt-Service Coverage Ratio?
In corporate finance, the debt-service coverage ratio (DSCR) is a measurement of the cash flow available to pay current debt obligations. The ratio states net operating income as a multiple of debt obligations due within one year, including interest, principal, sinking-fund and lease payments.
In government finance, it is the amount of export earnings needed to meet annual interest and principal payments on a country's external debts. In personal finance, it is a ratio used by bank loan officers to determine income property loans.
In each case, the ratio reflects the ability to service debt given a particular level of income.
- DSCR is a measure of the cash flow available to pay current debt obligations.
- DSCR can be used in analyzing firms, projects, or individual borrowers.
- The minimum DSCR a lender will demand depends on macroeconomic conditions. If the economy is growing, lenders may be more forgiving of lower ratios.
Debt-Service Coverage Ratio Formula
In general, the debt-service coverage ratio is calculated as:
DSCR=Total Debt ServiceNet Operating Incomewhere:Net Operating Income=Revenue−Certain Operating ExpensesTotal Debt Service=Current debt obligations
How to Calculate DSCR
The Debt-Service Coverage Ratio (DSCR)
The formula for debt-service coverage ratio requires net operating income and total debt service of the entity. Net operating income is a company's revenue, minus its operating expenses, not including taxes and interest payments. It is often considered the equivalent of earnings before interest and tax (EBIT).
Some calculations include non-operating income in EBIT, however, which is never the case for net operating income. As a lender or investor comparing different companies' credit-worthiness – or a manager comparing different years or quarters – it is important to apply consistent criteria when calculating DSCR. As a borrower, it is important to realize that lenders may calculate DSCR in slightly different ways.
Total debt service refers to current debt obligations, meaning any interest, principal, sinking-fund and lease payments that are due in the coming year. On a balance sheet, this will include short-term debt and the current portion of long-term debt.
Income taxes complicate DSCR calculations because interest payments are tax deductible, while principal repayments are not. A more accurate way to calculate total debt service is therefore to compute:
Total Debt Service=(Interest×(1−Tax Rate))+Principal
Calculating DSCR Using Excel
To create a dynamic DSCR formula in Excel, you would not simply run an equation that divides net operating income by debt service. Rather, you would title two successive cells, such as A2 and A3, "Net Operating Income" and "Debt Service." Then, adjacent from those in B2 and B3, you would place the respective figures from the income statement.
In a separate cell, enter a formula for DSCR that uses the B2 and B3 cells rather than actual numeric values (e.g., B2 / B3).
Even for a calculation this simple, it is best to leave behind a dynamic formula that can be adjusted and recalculated automatically. One of the primary reasons to calculate DSCR is to compare it to other firms in the industry, and these comparisons are easier to run if you can simply plug in the numbers and go.
What Does DSCR Tell You?
Lenders will routinely assess a borrower's DSCR before making a loan. A DSCR of less than 1 means negative cash flow, which means that the borrower will be unable to cover or pay current debt obligations without drawing on outside sources – without, in essence, borrowing more.
For example, DSCR of .95 means that there is only enough net operating income to cover 95% of annual debt payments. In the context of personal finance, this would mean that the borrower would have to delve into his or her personal funds every month to keep the project afloat. In general, lenders frown on negative cash flow, but some allow it if the borrower has strong resources outside income.
If the debt-service coverage ratio is too close to 1, say 1.1, the entity is vulnerable, and a minor decline in cash flow could make it unable to service its debt. Lenders may in some cases require that the borrower maintain a certain minimum DSCR while the loan is outstanding. Some agreements will consider a borrower who falls below that minimum to be in default. Typically, a DSCR greater than 1 means the entity – whether a person, company or government – has sufficient income to pay its current debt obligations.
The minimum DSCR a lender will demand can depend on macroeconomic conditions. If the economy is growing, credit is more readily available, and lenders may be more forgiving of lower ratios. A broad tendency to lend to less-qualified borrowers can, in turn, affect the economy's stability, however, as happened leading up to the 2008 financial crisis. Subprime borrowers were able to obtain credit, especially mortgages, with little scrutiny. When these borrowers began to default en masse, the financial institutions that had financed them collapsed.
Example of How to Use DSCR
Let's say a real estate developer is looking to obtain a mortgage loan from a local bank. The lender will want to calculate the DSCR to determine the ability of the developer to borrow and pay off his loan as the rental properties he builds generates income.
The developer indicates that his net operating income will be $2,150,000 per year and the lender notes that debt service will be $350,000 per year. The DSCR can thus be calculated as 6.14x, which should mean the borrower can cover his debt service more than six times over given his operating income.
Interest Coverage Ratio vs. DSCR
The interest coverage ratio serves to measure the amount of a company's equity compared to the amount of interest it must pay on all debts for a given period. This is expressed as a ratio and is most often computed on an annual basis.
To calculate the interest coverage ratio, simply divide the earnings before interest and taxes (EBIT) for the established period by the total interest payments due for that same period. EBIT, often called net operating income or operating profit, is calculated by subtracting overhead and operating expenses, such as rent, cost of goods, freight, wages and utilities, from revenue. This number reflects the amount of cash available after subtracting all expenses necessary to keep the business running.
The higher the ratio of EBIT to interest payments, the more financially stable the company. This metric only takes into account interest payments and not payments made on principal debt balances that may be required by lenders.
The debt-service coverage ratio is slightly more comprehensive. This metric assesses the ability of a company to meet its minimum principal and interest payments, including sinking fund payments, for a given period. To calculate DSCR, EBIT is divided by the total amount of principal and interest payments required for a given period to get net operating income (NOI). Because it takes into account principal payments in addition to interest, the DSCR is a slightly more robust indicator of a company's financial fitness.
In either case, a company with a ratio of less than 1 does not generate enough revenue to cover its minimum debt expenses. In terms of business management or investment, this represents a very risky prospect since even a brief period of lower-than-average income could spell disaster.
Limitations of DSCR
A limitation of the interest coverage ratio is the fact that it does not explicitly consider the ability of the firm to repay its debts. Most long-term debt issues contain provisions for amortization with dollar sums involved comparable to the interest requirement, and failure to meet the sinking fund requirement is an act of default which can force the firm into bankruptcy. A ratio that attempts to measure the repayment ability of a firm is the fixed charge coverage ratio.