What is Debt Service Coverage Ratio (DSCR) and How to Calculate it?
The debt service coverage ratio is an indicator of financial health of a company. It can be applied in corporate, government, or personal finance scenarios. It is especially helpful in the case of highly levered companies that are deep in debt. Different DSCR metrics are useful to different stakeholders, lenders, and partners. Other factors that are considered apart from DSCR include the company’s history, the industry it operates in, past relationships with lenders, and product pipeline.
In the corporate finance context, DSCR measures the amount of cash available to clear current debts. Investors use this ratio to assess whether the company can pay its debts using its income.
Why is Debt Service Coverage Ratio (DSCR) Important?
DSCR ratio is critical for businesses that have outstanding debts. This is because the DSCR is an indicator of their ability to clear both the principal and interest components of their debts. Knowing the DSCR calculation formula and understanding the meaning of the result can help businesses to evaluate their finances. It also helps them to identify areas for improvement.
Apart from financial management, DSCR also helps to establish the creditworthiness of the company. Lenders use this ratio to determine if they want to offer a business loan to the company. A high-risk borrower is characterized by a low or negative DSCR and lenders prefer companies with high DSCR over them.
However, it is noteworthy that a lower DSCR doesn’t necessarily indicate risk. The DSCR of a company can be analysed by comparing it to the DSCR of other companies in the same industry or the industry average. This is because different industries have different operational structures and it is inappropriate to compare companies that generally use debt to those that use more equity financing.
The benefits of a good DSCR include a higher chance of loan approval, low-interest rates on loans, more financing options and improved organizational operations.
What is the Debt Service Coverage Ratio Used for?
Debt service coverage ratio is mostly used for the three purposes below:
1. To Check Loan Eligibility
Lenders use DSCR to understand whether a company would be able to repay a borrowed sum and the interest on it. This helps them to decide whether to offer a loan to the company.
2. To Make Investment Decisions
Potential investors, existing shareholders and prospective business buyers use DSCR to understand the financial well-being of the company and the dividend they can earn in the future. In simple terms, it is an indicator of the amount of money left over for shareholders or investors.
3. To Help the Business Devise Strategies
Business owners can use debt service ratio to assess their growth potential and seek extra financing. It also helps with financial forecasting for a big investment or to make strategic decisions for the company.
Debt Service Coverage Ratio Formula
The basic concept behind DSCR calculation is:
[Cash flow +/- Adjustments]/ [Interest + Principal]
Generally, the calculation of debt service coverage involves using EBITDA for cash flow. The extent of adjustments will differ based on the context of the analysis. Below is the most commonly used DSCR formula:
Debt Service Coverage Ratio = [EBITDA – Cash Taxes] / [Interest + Principal]
Here,
- EBITDA denotes earnings before interest, tax depreciation and amortization
- The principal is the total amount borrowed that is due to be paid within the measurement period. In most cases, the measurement period is expressed as CPLTD, i.e. current portion of long-term debt
- Interest is the total interest accrued within the measurement period. This is calculated on both current and non-current portions of long-term debt
- Cash Taxes are the proportion of payable income tax during the measurement period
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How to Calculate the Debt Service Coverage Ratio?
A company’s net operating income is required for DSCR calculation. Net operating income refers to earnings before taxes and interest. Additionally, total debt service value, i.e. scheduled interest, principal, and lease payments for the subsequent year, is also required.
The formula is below:
Net Annual Operating Income ÷ Total of Annual Loan Payments
To make the calculation more accurate, the total debt service figure is reduced by the beneficial effect of deducting interest payments on income taxes.
Businesses may require to calculate the ratio regularly and track it by plotting on a trend line. This is because there may be substantial variation in the net annual operating income figure over time.
There may also be variation in the debt service figure if a variable interest rate applies to the debt. Due to these two factors, there may be significant variation in the results of debt service coverage ratio calculation.
Here is an example to illustrate DSCR calculation:
The annual cash flow of a business is Rs.35,00,000 and the total annual loan payments are Rs.9,00,000. This will yield a debt service ratio of 3.88. This means that based on the operating income, the borrower can cover the debt service more than 3 times.
What is a Good DSCR Ratio?
Whether a DSCR is good or not will depend on the industry the company operates in, its competitors and the stage where it is in its growth journey. For example, DSCR expectations are lower with smaller and more nascent companies that are just starting to generate cash flow as compared to well-established organizations. Generally, a DSCR above 1.25 is regarded as strong and that below 1.00 indicates financial issues.
How to Increase DSCR Ratio?
Increasing the net operating income of a business can help to increase the DSCR of a business:
1. Increasing the Net Operating Income
A business can increase its net operating income in one of the following ways:
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
Any debts that are paid off will also be removed from the DSCR equation.
5. Reducing the Amount of Loan Applied For
Reducing the amount you seek loan for will reduce the DSCR.
Interest Coverage Ratio Vs. Debt Service Coverage Ratio
The interest coverage ratio is an indicator of the number of times a company’s operating profit will cover the interest on its debts. The difference between this approach and the debt service coverage ratio is that the DSCR also accounts for the company’s ability to pay the principal and not just interest. The DSCR is generally more realistic than the interest coverage ratio, except in cases when there is no principal payable in the subsequent year. In such cases, both calculations yield the same results.
If both the calculations yield a ratio of less than 1, the company is not earning enough income to pay for its current debt obligations, thus making the company a risky borrower for any lender.
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, it is wise to do some extra bookkeeping to calculate the principal payments made in an accounting period.
Companies can also ease out calculations and reduce inaccuracies by asking the 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 gotten 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 recognized 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
DSCR is a widely used and implemented financial ratio that lenders and external parties commonly use DSCR to mitigate risk in lending. 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.
FAQs
Ans: 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.
Ans: 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.
