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Meaning Of Debt Service Coverage Ratio
The Debt Service Coverage Ratio (DSCR) measures a company's ability to use its operating income to pay off all of its debt obligations, including the repayment of principal and interest on both short- and long-term debt. The DSCR is calculated by dividing a company's operating income by the total amount of debt it owes. When a company has any borrowings on its balance sheet, such as bonds, loans, or lines of credit, this ratio is frequently used to determine how profitable the company is. As a credit metric in a leveraged buyout transaction, it is frequently used along with other credit metrics such as total debt/EBITDA multiple, net debt/EBITDA multiple, interest coverage ratio and fixed charge coverage ratio to evaluate the debt capacity of the target company.
Formula
Where:
EBITDA = Earnings Before Interest, Tax, Depreciation, and Amortization
Principal = The total loan amount of short-term and long-term borrowings
Interest = Interest payable on any borrowings
Capex = Capital Expenditure
Some businesses may prefer to use the latter formula because capital expenditure is not expensed on the income statement, but is instead treated as a "investment" by the accounting system. By excluding CAPEX from EBITDA, the company will be able to determine the actual amount of operating income available to pay down debt.
Interpretation of the Debt Service Coverage Ratio
It means that the borrower does not have enough cash flow to cover their debt payments if the debt service coverage ratio (DSCR) is less than 1. For example, if the debt-to-income ratio is 0.85, it indicates that the borrower only has enough net income to cover 85 percent of their debt payment, and that they will need to use personal funds or some other source of income to cover the remaining 15 percent of their debt payment obligations.
If the debt service coverage ratio (DSCR) is very close to one, such as 1.0 or 1.1, it indicates that the borrower has just enough cash flow to meet their debt payment obligations. If, on the other hand, the borrower experiences a slight decrease in cash flow, they may find themselves unable to make their debt payments. Depending on the circumstances, the lender may require the borrower to meet and maintain a specific DSCR minimum over the course of the loan's duration.
A debt service coverage ratio (DSCR) greater than one, such as 1.6, indicates that the borrower has sufficient cash flow to cover their debt payments. Even though each loan is different and each has its own DSCR minimum, the majority of lenders prefer to see a DSCR minimum of between 1.22 and 1.44, with an ideal ratio of 2.0 or higher being the most desirable. When a borrower has other assets besides their primary source of income, a lender may agree to a lower debt-to-income ratio (DSCR).
What Is a Good DSCR?
A "good" DSCR varies depending on the company's industry, competitors, and stage of development, among other factors. DSCR expectations may be lower for a smaller company that is just starting to generate cash flow than they are for a mature company that is already well established, for example. Generally speaking, a DSCR greater than 1.25 is considered "strong," whereas a ratio less than 1.00 may indicate that the company is experiencing financial difficulties.
Difference between debt service coverage ratio and interest coverage ratio
Lenders typically want to assess the health of a company by determining its ability to pay its interest and debts on a consistent basis. The debt service coverage ratio and the interest coverage ratio are the two most commonly used financial indicators. Despite the fact that they both look the same, they are based on entirely different factors.
The interest service ratio is a measure of a company's equity in relation to the interest paid on the debts that the company is currently owing.
An organization's interest service ratio is calculated by dividing net operating income by the interest paid on debts held by the organization over a period of time.
While the debt service ratio takes into account the principal and sinking funds, the interest service ratio does not take these factors into consideration.
The interest service ratio is not a reliable indicator of a company's financial health, and as a result, it should not be used to determine the borrower's eligibility.