What is Debt Service Coverage Ratio: Meaning, Formula and Importance
The debt service coverage ratio of an entity provides critical information about its debt-repaying capability. It applies to every sector of the economy, be it government, corporations, or individuals.
Financial institutions use the DSCR credit metric to determine the amount of loan that can be approved for an entity as well as decide the terms of repayment. Continue reading to know how lenders use the ratio to ascertain the creditworthiness of an entity.
What Is Debt Service Coverage Ratio?
The value of Debt Service Coverage Ratio (DSCR) helps to determine how a company’s operating cash flow can service its outstanding debt. It is an important metric that financial institutions use to assess the solvency of an entity.
The ratio is computed by dividing an entity’s net operating income by its total outstanding debt obligation. If the ratio value is more than one, it indicates the organization has an adequate cash flow or operating income to repay its debts.
On the other hand, if the value of the ratio is less than one, it indicates that the said entity does not generate sufficient cash flow to service its debt obligations. Financial institutions may not provide loans to such entities, and even if they lend some money to the specific entity, it will come with stringent repayment terms.
What Is the Formula for Debt Service Coverage Ratio?
The formula for debt service coverage ratio is as follows:
Debt Service Coverage Ratio = Total Operating Income / Total Outstanding Debt
You can calculate the operating income and the outstanding debt by using the formulas mentioned below:
Total Operating Income = Net Revenue – Certain Operating Expenses
Total Outstanding Debt = Interest Component + Principal Component of Debt
How to Calculate Debt Service Coverage Ratio?
Now, let's move on to how to calculate debt service coverage ratio. Suppose Company XYZ wants to borrow a loan from the bank. In order to process the loan amount, the said company furnishes some crucial information which is as follows:
Total revenue = ₹725,000
Operating costs = ₹225,000
Interest obligations = ₹75,000
Principal obligation = ₹115,000
Therefore, the net operating income will be,
Total revenue – Operating costs = ₹725,000 - ₹ 225,000 = ₹500,000
Additionally, the total debt expenses will be,
Interest + Principal = ₹75,000 + ₹115,00 = ₹190,000
So, by using the DSCR formula, the debt service coverage ratio of the entity will be,
Debt Service Coverage Ratio = ₹500,000 / ₹190,000 = 2.6
Therefore, as seen from the above calculations, the debt service coverage ratio is more than one indicating that the company is in a sound financial position to service its debt. This metric will allow the bank to approve their loan request on relaxed terms and conditions.
What Does Debt Service Coverage Ratio Indicate?
This ratio broadly indicates how easily a company will be able to repay its debt obligations. In terms of government finances, it indicates the level of export or foreign earnings that a government will need in order to service its external borrowings.
This ratio considers the entire debt obligation and uses net revenue after deducting certain operating expenses to come up with a value. Whenever debt service coverage ratio is less than one, it signifies a negative cash flow, thereby outlining that the company will have to delve into their savings or borrow more in order to cover existing debt obligations.
For example, a DSCR of 0.90 means that the company can cover only 90% of its existing debt obligations from their regular income sources. On the other hand, a DSCR of more than one indicates that the company is capable of paying off its current debts. This clearly indicates that a company has strong creditworthiness.
What Is the Importance of DSCR?
Here are some reasons why a debt service coverage ratio is important for different stakeholders:
- It allows lenders to assess the creditworthiness of borrowing entities. Based on one's creditworthiness, financial institutions can move ahead with approval or rejection of loan applications.
- Banks and other institutions compute this ratio on an annualized basis. It is a better metric to observe than liquidity or leverage, which is measured at a particular point in time and may be misleading.
- Looking at debt service coverage ratios while deciding whether to grant a loan or not saves bankers from giving loans to entities who may not be able to repay that in full.
- Lenders assess the DSCR before approving real estate loans or investments. It only considers expected revenue from that property over a year rather than personal income of borrowers or buyers of that property. Hence, buyers not having recurring income may make the cut if that property generates sufficient income to cover the loan amount.
What Is a Good DSCR?
A debt service coverage ratio of more than one means positive cash flows for the company. On the other hand, a value of less than one denotes a negative cash flow position. According to various experts, an organisation should maintain their debt service ratio of around 1.25.
Although a value of more than one will be sufficient to cover existing debt obligations, a ratio value of just over one may be risky as there will always be a possibility of slipping below one in the near future.
A good DSCR may be subjective, with the value differing for one person over another. However, a ratio of more than 1.25 can be considered an ideal one.
The debt service coverage ratio is an important credit metric used by various lenders to assess the feasibility of granting a loan to prospective borrowers. Hence, every entity must try to keep its DSCR at more than one in order to lower its chances of rejection of loan applications.