Debt Service Coverage Ratio Formula

Debt Service Coverage Ratio Formula (Table of Contents)

Debt Service Coverage Ratio Formula
Examples of Debt Service Coverage Ratio Formula (With Excel Template)
Debt Service Coverage Ratio Formula Calculator

Debt service coverage ratio, as its name suggests, is the amount of cash a company has to service/pay its current debt obligations (interest on a debt, principal payment, lease payment etc.). It is calculated by dividing the company’s net operating income by its debt obligations for that particular year.

Here’s the Debt Service Coverage Ratio Formula –

Debt Service Coverage Ratio (DSCR) = Annual Net Operating Income / Total Debt Service

Net operating income is the income left when all the operating expenses are paid. In the Income statement, it is under the head EBIT (Earnings Before Interest and Taxes)Total debt service is basically all the debt related payments which a company needs to pay. For example interest payments, principal payments, and other obligations.

A DSCR greater than 1 is preferable and give us the indication that the company has enough cash to service its debt. Generally speaking, higher the DSCR, better it is for the business.

Examples of Debt Service Coverage Ratio Formula (With Excel Template)

Let’s take an example to understand the calculation of the Debt Service Coverage Ratio formula in a better manner.

You can download this Debt Service Coverage Ratio Formula Excel Template here – Debt Service Coverage Ratio Formula Excel Template

Debt Service Coverage Ratio Formula – Example #1

Suppose that company A is selling TVs and they have 2 stores as of now. They want to expand and want to open a new store but they do not have much cash in hand to invest now. So they want to explore the debt option and want to take a loan for that. The company already have a loan in their books so they are worried that they might not be able to get another loan. Following are the details of their financials:

Total Debt Payments is calculated using the formula given below

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Total Debt Payments = Interest + Principal + Lease + Other Debt Payments

Total Debt Payments = $30,000 + $25,000 + $15,000 + $15,000
Total Debt Payments = $85,000

Debt Service Coverage Ratio is calculated using the formula given below

Debt Service Coverage Ratio (DSCR) = Annual Net Operating Income / Total Debt Service

DSCR = $100,000 / $85,000
DSCR = 1.176

So it means that they have enough operating profit to service their current debt and will not face many difficulties to get another loan.

Debt Service Coverage Ratio Formula – Example #2

Let’s see some practical example and take some well know stocks from the market. Let’s take Ford for example. Following is its Income statement snippet:

Source Link: https://in.finance.yahoo.com/quote/FORD/financials?p=FORD

If you see the income statement of Ford:

Net Operating Income for 2018 is:

Net Operating Income for 2018 = Earnings before Interest and Taxes

Net Operating Income for 2018 = 556.652k

Debt Payment is:

Debt Payment = Interest Expenses

Debt Payment= 115.447k

Debt Service Coverage Ratio is calculated using the formula given below

Debt Service Coverage Ratio (DSCR) = Annual Net Operating Income / Total Debt Service

DSCR = 556.652 / 115.447
DSCR = 4.82

Explanation

If you are giving a loan to someone, you would not like that person to default on that and you lose your money. That is where Debt Service Coverage Ratio Formula helps the lender to understand how risky is the borrower and how likely is he is going to default. As explained above, debt service coverage ratio is the measure of a company’s ability to serve its debt obligation through its operating income. A higher ratio is always good and shows that enough operating income is present to cater to debt. If your debt coverage ratio is very low, the best way to improve is to reduce the loan amount in your books. This will make your principal and interest lower which in turn increase the ratio

But the lower ratio does not means that there is some problem in the company. Companies should always be benchmarked against their sector or industry. It very common in some industries that there is huge debt is involved, for example, the aviation industry. So we should not be comparing their DCSR with companies such as IBM, Accenture where there is very less debt. It is also one of the most critical ratios to analyze in case of leveraged buyout transaction because this will evaluate the debt capacity of the target company.

Relevance and Uses of Debt Service Coverage Ratio Formula

This ratio is really important, as stated multiple times above to sense what is the level of financial flexibility the business have, particularly in a growth situation. If the ratio is high, it means that there is higher ability with the business to invest and grow in the future. Similarly, if DSCR is low (less than 1 or slightly above 1), then businesses need to improve this ratio otherwise they will face difficulty to procure a loan from the lenders.

All lenders different risk appetite and different strategy in mind and some give more importance to DSCR than the others. So they use DSCR differently while entering into loan agreements with a borrower. Lenders, who only get paid back through company’s Cash flow (like mezzanine lenders), they give more focus on DSCR and they generally put a covenant in the agreement with an escalating ratio to make sure that money is coming. In nutshell, lenders have a greater control over this ratio because they are the one who will dictate the repayment of principal.