The debt service coverage ratio is a measure of the cash flow available to pay current debt obligations. The ratio states net operating income as a multiple of debt obligations due within one year, including interest, principal, sinking-fund and lease payments.
In government finance, it is the amount of export earnings needed to meet annual interest and principal payments on a country’s external debts. In personal finance, it is a ratio used by bank loan officers to determine income property loans.
The debt service coverage ratio is calculated as: DSCR = Net Operating Income / Total Debt Service
Components of the Debt Service Coverage Ratio
The formula for debt service coverage ratio requires net operating income and total debt service of the entity. Net operating income is a company’s revenue minus its operating expenses, not including taxes and interest payments. It is often considered equivalent of earnings before interest and tax (EBIT). Some calculations include non-operating income in EBIT, however, which is never the case for net operating income. As a lender or investor comparing different companies’ credit-worthiness – or a manager comparing different years’ or quarters’ – it is important to apply consistent criteria when calculating DSCR. As a borrower, it is important to realize that lenders may calculate DSCR in slightly different ways.
Total debt service refers to current debt obligations, meaning any interest, principal, sinking-fund and lease payments that are due in the coming year. On a balance sheet, this will include short-term debt and the current portion of long-term debt.
Income taxes complicate DSCR calculations because interest payments are tax deductible, while principle repayments are not. A more accurate way to calculate total debt service is therefore:
Interest + (Principle / [1 – Tax Rate])
Interpreting the Debt Service Coverage Ratio
Lenders will routinely assess a borrower’s DSCR before making a loan. A DSCR of less than 1 means negative cash flow which means that the borrower will be unable to cover or pay current debt obligations without drawing on outside sources—without, in essence, borrowing more. or example, DSCR of .95 means that there is only enough net operating income to cover 95% of annual debt payments. In the context of personal finance, this would mean that the borrower would have to delve into his or her personal funds every month to keep the project afloat. In general, lenders frown on a negative cash flow, but some allow it if the borrower has strong resources outside income.
If the debt-service coverage ratio is too close to 1, say 1.1, the entity is vulnerable, and a minor decline in cash flow could make it unable to service its debt. Lenders may in some cases require that the borrower maintain a certain minimum DSCR while the loan is outstanding. Some agreements will consider a borrower who falls below that minimum to be in default. Typically, a DSCR greater than 1 means the entity – whether a person, company, or government – has sufficient income to pay its current debt obligations
The minimum DSCR a lender will demand can depend on macroeconomic conditions. If the economy is growing, credit is more readily available, and lenders may be more forgiving of lower ratios. A broad tendency to lend to less-qualified borrowers can in turn affect the economy’s stability, however, as happened leading up to the 2008 financial crisis. Subprime borrowers were able to obtain credit, especially mortgages, with little scrutiny. When these borrowers began to default en masse, the financial institutions that had financed them collapsed.
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