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 Formula
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 –
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 gives us the indication that the company has enough cash to service its debt. Generally speaking, the higher the DSCR, the 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.
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 debit option and want to take a loan for that. The company already has 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 examples 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 the borrower is and how likely is he is going to default. As explained above, the 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 mean 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 little debt. It is also one of the most critical ratios to analyze in the case of leveraged buyout transactions 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 has, particularly in a growth situation. If the ratio is high, it means that there is a 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 have different risk appetites and different strategies 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 the 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 a nutshell, lenders have greater control over this ratio because they are the ones who will dictate the repayment of principal.
Debt Service Coverage Ratio Formula Calculator
You can use the following Debt Service Coverage Ratio Calculator.
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