Debt Service Coverage Ratio (DSCR) – Formula and Calculation
Debt Service Coverage Ratio or DSCR is a measurement of a firm’s short-term financial health. It provides a sense of whether a firm’s net available cash flow is sufficient to cover its outstanding debt liabilities.
Investors may use it as one of the many metrics to check the viability of their investment into a company. In fact, this ratio will indicate whether a company is overleveraged, making it a risky investment.
While the DSCR formula is most commonly used to check the creditworthiness of a business, it is often issued to assess the same for individual borrowers, governments, and institutional investors.
How Does the Debt Service Coverage Ratio (DSCR) Work?
DSCR is an important metric for businesses, lenders, as well as investors. Depending on its DSCR, a company can decide whether it is fit to raise a loan from the market or issue sale of bonds. If yes, this ratio can also help the company fix the rate of interest it wants to offer on its bonds. Additionally, a lender will use it to assess whether the current net income of the business is sufficient to pay for its outstanding loans, based on which it can decide whether it wants to approve a fresh loan and the terms of lending. An investor can use this metric to evaluate the financial health and leverage of the company, and whether they should invest in it.
Debt Service Coverage Ratio (DSCR) is important for a company for another reason. It helps a company determine its capital structure – which is the percentage of debt and equity used by a company to fund its growth initiatives and daily operations. If the DSCR is too low for a business i.e. it is overleveraged, it may be forced to raise capital through the equity route, which is generally costlier. If DSCR is high, a company may prefer to raise capital through the debt channel, which means lower cost and less dilution of ownership.
Why is Debt Service Coverage Ratio (DSCR) Important?
- Helps a lender gauge a company’s creditworthiness.
- Helps an investor estimate the level of leverage, quality of financial management, and financial health of a company – which gives a sense of the company’s financial stability.
- DSCR, when used in conjunction with liquidity and leverage of a company, may help study the financial performance of a company over the long term.
- Higher DSCR will help a business get loans at more favourable terms and could also help increase the rate of subscription to debentures and debts issued by the company.
- May help attract strategic partners and investors, who generally use this metric to check the ability of a company to pay off its debts and stay financially stable.
What is the Debt Service Coverage Ratio Used for?
Debt service coverage ratio is typically used for the following:
1. To Check Loan Eligibility of a Company or Individual
Lenders use DSCR to understand whether a company or an individual has sufficient and steady income to repay a loan on time. Depending on how high or low the DSCR value is, the lender could either reject the application, approve the loan at a high rate of interest and with or without additional conditions, or offer the loan at a relatively favourable condition.
2. To Make Investment Decisions
Potential investors, existing shareholders, and prospective business buyers use DSCR to understand the financial well-being of a company and gauge how safe their investment decision is. In simple terms, it is an indicator of whether the net income is enough to pay off the outstanding loans, have sufficient balance to fund the company’s growth and operations, and still have excess cash to give back to investors, either in the form of dividends and through share buyback among others.
3. To Help a Business Devise Strategies
Business owners can use the debt service ratio to assess their growth potential and seek extra financing, whenever needed, to expand or capture opportunities in the market. It also helps with financial forecasting – which is important to attract new investors or other key stakeholders.
Debt Service Coverage Ratio Formula
The DSCR formula is given by:
- DSCR = Net Operating Income ÷ Total Outstanding Debt (i.e. debt service)
- Where Net Operating Income = Revenue – Operating Expenses
On many occasions, a business or its lenders/investors may use EBITDA or EBIT instead of net operating income in the formula for DSCR,
Where EBITDA (earnings before interest, tax, depreciation, and amortisation) = Pre-tax income + Interest + Depreciation and Amortisation
And EBIT (earnings before interest and taxes) = pre-tax income + interest payable on outstanding debt + applicable taxes
How to Calculate the Debt Service Coverage Ratio?
The Debt Service Coverage Ratio formula for a company is calculated by considering its net operating income and its debt servicing costs.
Net operating income for a company is the income left after all the operating costs, excluding taxes, interest payable, and any loss borne out of sale of a capital asset, have been settled. The debt servicing cost is the total cost of repaying the company’s outstanding debt liabilities. It may also include the funds kept separately to meet future debt obligations, often referred to as a company’s sinking fund obligation.
DSCR Calculation Explained With an Example
Let us assume that company A has a net operating income of ₹75 Lakh. We can also assume that they have to pay ₹15 Lakhs per year on interest on their outstanding loans, ₹25 Lakh is the combined principal on the debt obligations, and ₹10 lakh is earmarked as sinking fund obligation. Then, DSCR for the company will be as follows:
- DSCR = ₹75 Lakh/₹(15 Lakh + 25 Lakh + 10 Lakh) = 75,00,000/50,00,000 = 1.5
Now, a Debt Service Coverage Ratio of 1.5 means that even after settling its debt obligations, company A will still have 50% of its net operating income.
Also Read
How to Calculate Debt Service Coverage Ratio (DSCR) Using Excel?
Calculating the DSCR formula becomes extremely convenient with Excel. Let’s see how:
Let us earmark column A for Particulars and column B for Values. You can enter your company’s net operating income in cell A2 and the value in cell B2. Now, to calculate the company’s debt servicing expenses, you will have to add up the following:
Enter interest expenses for the whole year in A3 and the value in B3, principal obligations in A4 and the value in B4, lease payments in A5 and the corresponding value in B5, sinking fund obligations in A6 and the value in B6, other debt obligations in A7 and the corresponding value in B7.
Now, the added value can be entered in B8 next to total debt servicing expense. To add up these values, you will have to use the formula =SUM(B3,B4,B5,B6,B7), which will appear in cell B8.
In cell A9, you can enter DSCR and the corresponding value in cell B9. To find this value, use this formula =B2/B8.
Let us Understand this with an Example.
Let’s say the operating income of Company XYZ is ₹75 Lakh. Enter them in cells A2 and B2 respectively. Let the Interest expenses, principal payments, lease obligation, sinking fund value, and other debt obligations be ₹15 Lakh, ₹17 Lakh, ₹7 Lakh, ₹5 Lakh, and ₹3 Lakh respectively. These values have to be entered in cells B3, B4, B5, B6, and B7 respectively. The sum of these can be entered in cell B8 with the formula =SUM(B3,B4,B5,B6,B7) = ₹47 Lakh. Now, the DSCR can be found with the formula =B2/B8 = 1.595744681. This will appear in cell B9.
The following screenshots will give you a better idea:
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What is a Good DSCR Ratio?
DSCR is considered to be good when it is between 1.2 and 1.25. However, a good DSCR ratio would depend on the eligibility criteria set by a lender or the risk tolerance of an investor.
However, in general, a Debt Service Coverage Ratio (DSCR) of 2 is considered to be extremely good for most organisations, irrespective of size, industry, and financial objectives.
How to Increase DSCR Ratio?
To increase the DSCR ratio, a company will either have to increase their net operating income, reduce their debt servicing expenses, or simultaneously achieve both. The following are some methods for increasing DSCR:
1. Increasing the Net Operating Income
A company could increase its net operating income by increasing its net profit or sales, or by reducing its utility expenses, labour expenses, and operating expenses.
2. Decreasing Expenses
Businesses can look at the net payments they make and check if they can cut down on some expenses or re-negotiate with any vendors.
3. Increasing Efficiency
Businesses can cut costs by eliminating redundancies in their processes and looking at ways to increase performance.
4. Clearing Existing Debts
A company should also aim to reduce its debt expenses, which will help lower the value of the denominator in the DSCR formula and help increase the DSCR value.
5. Not Applying for Fresh Debt
If a company’s DSCR is too high, it should not only look to reduce the amount it spends on servicing its existing loans, but should also stop applying for new loans.
Advantages and Disadvantages of DSCR
The following are some important advantages and disadvantages of Debt Service Coverage Ratio (DSCR):
| Advantages | Disadvantages |
| Can help analyse the financial performance trend of a company over a period of time. | There is no single standard formula. While some lenders prefer net operating income, others consider EBIT or EBITDA. |
| Could be used by an investor to compare the financial health and operational efficiency of multiple companies they may be considering for investment. | Since it may not consider the tax and interest cost obligations of a company, it does not always give an accurate picture of the financial stability or profitability of a company. |
| Since it is considered on a rolling annual basis, it could provide a more accurate and exhaustive view of a company’s financial health. | Does not give a comprehensive idea about the company’s expenses, since the formula doesn’t consider obligations, such as tax. |
Interest Coverage Ratio Vs. Debt Service Coverage Ratio
| Interest Coverage Ratio | Debt Service Coverage Ratio |
| The interest coverage ratio (ICR) is a measure of a company’s ability to pay off the interest expenses on its debt, based on its net operating income. | The debt service coverage ratio (DSCR) is a measure of a company’s ability to meet its debt obligations, including principal and interest, based on its net operating income. |
| ICR formula = Net operating income ➗ Interest expenses of outstanding debt | DCR formula = Net operating income ➗ Debt servicing expenses |
| Interest coverage ratio may be a less accurate metric since it doesn’t consider the principal payment obligations. | It offers a more comprehensive picture of a company’s ability to repay its outstanding debt. |
Mistakes to Avoid When Calculating the Debt Service Coverage Ratio
1. Principal Repayment Amount
The calculation of principal amount is among the common reasons for errors while calculating the debt service coverage ratio. Since principal payments are not mentioned on income statements and only the outstanding balances are mentioned on balance sheets. So, it may be prudent to put extra effort into bookkeeping to calculate the principal payments made during an accounting period.
A company can make their life and the calculation easier by asking a lender for separate repayment schedules for all loans and using them to estimate the principal amounts. The bottom line is to calculate these amounts as accurately and carefully as possible.
2. Capital Lease Expenses
The next confusion that arises is over the inclusion of capital lease expenses in the calculation. When, for accounting purposes, the long-term lease of an asset is regarded as the purchase of the asset, it is termed a capital lease. For instance, a business may lease a piece of equipment with a useful life of 5 years for 3 years and the company can buy it at fair value after the lease expires.
Special accounting rules are applied to record these lease types. This is because the lessor has got full economic value from the asset as if it was purchased. Some lenders do not include capital lease expenses in debt service coverage ratio calculations, whereas some other analysts include them. The resultant metric, if the capital lease expenses are considered, is called the fixed-charge coverage ratio.
3. EBITDA vs EBIT
Another prominent confusion with debt service coverage ratio calculation is whether to use EBITDA or EBIT. EBIT refers to earning before taxes and either EBITDA or EBIT can be used. The cause of confusion is that EBITDA is generally not mentioned in a company’s income statement. This is because the Generally Accepted Accounting Principles or GAAP hasn’t recognised EBITDA.
EBITDA calculation uses figures from the income statement. The formula for EBITDA is below:
- EBITDA = Net Profit + Interest + Taxes + Depreciation and Amortisation
Final Word
Debt Service Coverage Ratio (DSCR) is a widely used financial metric that lenders and investors use to evaluate the creditworthiness and financial stability of a company. It is the ratio of the company’s operating income to its debt payments and helps to assess a company’s capability to repay the principal and interest.
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FAQs
Most jurisdictions regard income taxes to regional and federal governments as liabilities of the highest priority. Thus, the cash portion of taxes must be paid to avoid operational intervention from tax authorities.
The cash flow on the cash flow statement also includes relaxation or tightening of payment deadlines, changes in inventory turns, and changes in payment collection frequency from customers. Since these fluctuate and are dependent on supply chain and market dynamics, the cash flow from these statements doesn’t always indicate the company’s capability to generate consistent income from its business operations. Thus, EBITDA is used for calculation.
Yes, higher DSCR is better since it indicates that a company has more than sufficient net operating income to meet its debt obligations – which is an indication of the company’s financial stability and growth.
While the ideal DSCR ratio could vary based on the size of a company and its industry, a good DSCR ratio is considered to be somewhere between 1.2 and 1.25.
A DSCR of 1.25 means that the company has sufficient net operating income to repay its debt servicing expenses and still have 25% of the operating income left to explore growth opportunities and further its expansion plans.
If DSCR is zero, it means that a company has no net operating income. In such a circumstance, some lenders may still approve a loan, provided the borrower has a decent CIBIL score and or they pledge a valuable asset. From an investor’s perspective, a DSCR of zero may not give sufficient information into how well the company is managed or how leveraged it is.
