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The Debt Service Coverage Ratio, or DSCR, is a key measurement of a company’s cash flow and its ability to meet debt obligations. Along with other debt capacity metrics, DSCR is an important indicator of a business’s financial health. In this article, we are going to explain how DSCR is calculated and how it is used by lenders and investors when making financial decisions.
Highlights/ Key Takeaways
- The Debt Service Coverage Ratio is a credit metric that measures whether a company can cover its debt obligations with its operating cash flow.
- DSCR helps lenders, investors, and other stakeholders understand the financial health of a company.
- A higher DSCR is better than a lower one: a ratio below 1.2 could mean a company may struggle to repay debt.
- Improving DSCR comes down to increasing the company’s income or reducing principal and interest payments on the existing debt.
What is Debt Service Coverage Ratio?
The Debt Service Coverage Ratio assesses a company’s ability to use its cash flow to repay existing debt, take on new loans, and issue dividends to shareholders.
Lenders typically use DSCR when evaluating the company’s creditworthiness and deciding whether to approve a loan application. At the same time, investors use the ratio to understand the financial health of a company and determine whether it is a worthwhile investment. Finally, companies use the DSCR metric internally to plan ahead and understand their ability to secure additional financing.
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“In a nutshell, DSCR assesses a company’s ability to use its cash flow to repay existing debt, take on new loans, and issue dividends to shareholders.”
Why Debt Service Coverage Matters
The Debt Service Coverage Ratio is an important indicator of a company’s financial health and is used by outside parties and internal stakeholders alike.
For example, a strong DSCR can help a company get approved for loans and receive better interest rates and more favorable loan terms. When used internally, DSCR can help a company's leadership to identify areas for financial improvement and make a corresponding plan for the future.
Pros and Cons of Using DSCR
The Debt Service Coverage Ratio provides great flexibility and can be used by lenders, investors, and companies alike. For example, investors can use DSCR to compare different companies when making investment decisions. At the same time, it can give the company itself a great overview of how strong its cash flow is.
While DSCR includes more information than some other financial ratios, it still does not provide a full picture of the company’s health. Furthermore, different lenders may take varying approaches to the Debt Service Coverage Ratio calculation, - so it is important to understand these differences.
| Pros of Using DSCR | Cons of Using DSCR |
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Calculating Debt Service Coverage Ratio
To evaluate a company’s Debt Service Coverage Ratio, two main metrics are required: Net Operating Income and Debt-Service.
Net Operating Income is the pre-tax amount that reflects gross income minus operating expenses like rent or lease payments, goods sold, taxes, parking, and equipment, as well as amortization and interest in a given period. However, Net Operating Income does not include capital expenditures, - for example those related to acquiring and maintaining fixed assets.
Debt-Service is simply the cash amount required to cover principal and interest payments on a loan during a given period.
The Debt Service Coverage Ratio Formula
While DSCR may be calculated in slightly different ways, the most common approach uses the following Debt Service Coverage Ratio formula:
DSCR = Annual Net Operating Income / Annual Debt-Service
Here, Net Operating Income can be calculated as gross income minus operating expenses, while Debt-Service is the sum of all current debts, including interest and principal.
Example
Company ABC has a net operating income of $100,000 and an annual debt service of $67,000. Its Debt Service Coverage Ratio can be calculated as:
DSCR = $100,000 / $67,000 = 1.49
Understanding the Results
When it comes to DSCR, the higher - the better. Most lenders have a minimum Debt Service Coverage Ratio requirement of 1.2 to 1.25, meaning that they would not extend a loan to applicants with a ratio falling under this threshold.
In general, you can interpret your DSCR calculation result as follows:
- DSCR < 1: A company has negative cash flow and will likely be unable to repay its debts.
- DSCR = 1: A company may be at risk of being unable to repay debts if it experiences a decline in cash flow.
- DSCR > 1: A company is generally considered capable of repaying its debt.
Example
ABC’s Debt Service Coverage Ratio was calculated to be 1.49. This is well above 1, which means that Company ABC can likely repay its debt and presents a low financial risk. ABC could likely get approved for loans with great rates and terms.
How Lenders and Investors Use Debt Service Coverage Ratio
Lenders often evaluate a borrower’s DSCR before deciding whether they wish to offer a loan and how much they are willing to lend. For example, a DSCR of less than one means that a company will not be able to cover current debt obligations with regular cash flow and would need to continue borrowing more.
While a DSCR that falls below one will most likely get a company’s loan application rejected, there is no industry standard for the DSCR cut-off. Different lenders will make different decisions based on the same DSCR, - but, for most, a DSCR of 1.2 to 1.25 is considered sufficient.
A company’s ability to pay its debts is also an important factor for individual investors. They often use DSCR to understand the financial health of their companies of interest and make investment decisions accordingly.
It is worth noting, however, that DSCR is rarely used as a single metric of a company’s financial health. Instead, it is evaluated along with other metrics, such as the debt-to-equity ratio and debt-to-EBITDA ratio.
Different Types of DSCR and Their Applications
In addition to DSCR, other types of coverage ratios can be used to measure the company’s ability to repay its debt. The most common coverage ratios include:
- Global DSCR. The Global DSCR is the most commonly used coverage ratio. It measures the borrower’s ability to repay all debt obligations, including principal and interest, with available cash flow.
- Fixed Charge Coverage Ratio (FCCR). The FCCR measures a company’s ability to cover its fixed financial obligations, including lease and interest payments, with its available cash flow.
- Interest Coverage Ratio (ICR). The Interest Coverage Ratio measures a company’s ability to cover the interest payments on the outstanding debt with its EBIT, or Earnings Before Interest and Taxes.
- Cash Flow Coverage Ratio (CFCR). The Cash Flow Coverage Ratio measures the borrower’s ability to cover all of its financial obligations with available cash flow.
- Collateral Coverage Ratio. The Collateral Coverage Ratio is calculated as the aggregate value of the relevant collateral security divided by the outstanding aggregate principal amount of the debt. Simply put, it is the percentage of a loan that is secured by the collateral.
- Debt Yield Ratio. The Debt Yield Ratio is used to evaluate a property’s net operating income in relation to the amount of debt used to purchase the property.
Debt Service Coverage Ratio vs. Interest Coverage Ratio
While DSCR measures a company’s ability to cover all of its debt payments, including principal and interest, the Interest Coverage Ratio (ICR) takes the calculation one step further. As such, with ICR, one can determine how much interest payments the company can cover with the current net operating income.
These interest payments can include interest on mortgages, business loans, or credit cards. Just as with DSCR, the net operating income used to calculate ICR includes the income after expenses but before paying taxes and interest.
The Interest Coverage Ratio can be calculated as:
ICR = Operating Income / Interest Expense, where
Interest Expense is the total sum of interest payments paid on a company’s debt service.
Example
As in the previous example, Company ABC has a net operating income of $100,000 and an annual debt service of $67,000. Out of the $67,000 debt service, $55,000 is the principal loan amount, and $12,000 is the interest payment.
ABC’s ICR can be calculated as:
ICR = $100,000 / $12,000 = 8.33
How Can Companies Improve Their Debt Service Coverage Ratio?
Remember, DSCR is calculated as Net Operating Income divided by Debt-Service for a certain period. As evident from the formula, the two main paths to improving the Debt Service Coverage Ratio include either increasing the numerator (the income) or reducing the denominator (the amount of debt owed). However, there are other approaches you could take:
- Reduce interest rates. Companies can try to refinance loans to get a lower interest rate and, therefore, reduce total monthly or annual debt obligations.
- Negotiate better contract terms. To reduce net operating expenses, companies can try to negotiate better contract terms. For example, you could try to negotiate lower prices on raw materials, reduce shipping costs, or change vendors altogether.
- Work with a financial professional. Finally, an experienced financial professional can help companies to evaluate their balance sheets and income statements in order to identify ways to improve net operating income.
Once a good level of DSCR is achieved, it must be regularly reevaluated. To keep the Debt Service Coverage Ratio high, it is important to maintain or increase net operating income and avoid taking on excessive amounts of debt.
Important Terms Related to DSCR
To fully understand what DSCR is and how it is calculated, it is a good idea to review other relevant financial terms, including:
- Equity. Shareholder’s equity is the value of an investor’s stake in a company. It is equal to the company's total assets minus its total liabilities.
- Debt. In finance, debt is the sum of money borrowed for a certain period of time. All debt must be eventually repaid, along with the interest.
- EBITDA. EBITDA stands for Earnings Before Interest, Taxes, Depreciation, and Amortization. It is calculated as net income plus interest, taxes, depreciation, and amortization.
- Net Operating Income. Net Operating Income, or NOI, is a before-tax amount, which equals total revenue minus all reasonably necessary operating expenses associated with a particular investment.
- Debt-Service Interest. Debt-Service Interest is the cost of borrowing, or interest rate payments, within the company’s total debt service.
- Principal. The loan principal is the amount of money that you have originally borrowed and agreed to pay back along with interest.
- Risk appetite. Risk appetite is the amount of risk an individual or an organization is willing to take while pursuing its objectives or engaging in a particular investment.
Final Word
Without a doubt, using the Debt Service Coverage Ratio, or DSCR, is a simple, yet powerful, way to analyze a company’s ability to repay debt. It is not unusual for both lenders and investors to base important financial decisions on DSCR along with other debt ratios. Luckily, achieving a more desirable, higher DSCR comes down to simply reducing the company’s debt and increasing its operating income.
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