Debt Service Coverage Ratio: Meaning, Importance and Steps to Calculate DSCR
A debt service coverage ratio (DSCR) is an important credit metric useful for corporations, individuals, and state or federal governments. Along with debt equity and total debt assets ratio, DSCR is used by various financial institutions to ascertain their debt repayment capability.
DSCR is one of the most important factors determining whether the loan application will be approved. Read more about this concept and its implications in corporate financing.
What Is the Meaning of Debt Service Coverage Ratio?
DSCR reflects the creditworthiness of borrowers. It is computed by dividing the total net income of an entity by its current debt obligations, including principal and interest components over time.
However, several bankers and non-banking financing companies tweak this formula per their risk appetite or financing requirements. A higher DSCR or debt service coverage ratio indicates that the company's financial position is sound and capable of servicing its existing debt.
On the other hand, a DSCR value of less than one means that companies may have to seek external borrowings or delve into their savings to fulfil their debt requirements. Now that you know the meaning of DSCR let’s move on to its working.
What Does DSCR Tell You?
This ratio provides crucial insights into the financial solvency of an entity. In the case of a government entity, it signifies the external or export earnings required to fulfil its debt obligations.
A ratio value lower than one indicates negative cash flows for the organisation, meaning that they have to borrow more or delve into their savings to pay off their debt obligations. A ratio value of 0.95 means that the operating income of a particular entity can cover 95% of its existing debt, thereby requiring additional resources to fulfil its debt obligations.
On the other hand, a value of 1.10 means that the said entity has sufficient cash flows to service its debt. Investors also use DSCR to gauge the financial standing of a company. It gives them a fair idea about whether the company is in a position to offer them regular dividend payments.
What Is a Good DSCR?
A good debt service ratio is a subjective value that varies from one entity to another. There is no uniform threshold or value which signifies a good DSCR. However, as per the opinion of experts, a matter of more than 1.25 is considered an ideal DSCR that firms should try to maintain.
Having said that, even a low DSCR may not result in directly rejecting a loan application. It is one of the many factors considered while determining an entity's creditworthiness. Lenders may consider the loan application if the entity has satisfactory results on other parameters.
What Is the Debt Service Coverage Ratio Formula?
The formula for calculating DSCR is:
Debt Service Coverage Ratio = Net Operating Income / Total Existing Debt Obligation
How to Calculate Debt Service Coverage Ratio?
Financial institutions compute debt service coverage ratio by dividing net operating income by their total existing debt obligations. Let’s consider the calculation of DSCR with an example:
Suppose Company ABC applies for a loan from a non-banking financial institution. In order to receive approval for their loan, they have provided some information about their financials. The information is given as follows:
Total revenue: ₹540,000
Certain operating expenses: ₹210,000
Interest component on their current debt: ₹95,000
Principal components for the current year: ₹55,000
The first step in computing DSCR is deriving the net operating income of the company by using the following formula:
Net operating income = Total Revenue – Certain Operation Expenses
= ₹540,000 - ₹210,000 = ₹330,000
The next step involves computing total debt obligation for a period of time.
Total Debt Obligation = Interest Component + Principal Component
= ₹95,000 + ₹55,000 = ₹130,000
Therefore, the DSCR for Company ABC for a specific period is,
Debt Service Coverage Ratio = Net Operating Income / Total Debt Obligation
= ₹330,000 / ₹130,000 = 2.5
As this ratio is more significant than one, it means that entities have sufficient revenues to pay off their debt for that particular period.
What Is the Importance of Debt Service Coverage Ratio?
The importance of DSCR has been discussed below:
- Creditors use this ratio to assess the creditworthiness of various entities.
- Approving loans after considering DSCR allows bankers to avoid sanctioning loans to entities with default risk. This helps in reducing the quantum of bad loans for the lenders.
- Owners or founders of a company or an organisation use this ratio to assess the financial health of their company. It allows them to go ahead with strategic planning, reducing inefficiencies in their system and boosting revenues.
A debt service coverage ratio is an important metric that provides insight into the debt repayment capacity of an organisation. This article provides comprehensive and in-depth information about the working of DSCR. It is imperative for entities to maintain a positive DSCR to avail funding from banks and investors.