What is debt service coverage ratio (DSCR)
The full of DSCR is Debt service coverage ratio. DSCR is a debt financial ratio. It measures the cash flow ready to pay firm’s current debt obligations.
This ratio presents net operating income as a multiple of debt obligations due in one year, including interest, principal, sinking-fund and lease payments.
In government finance, it is the indispensable amount of export income needed to meet up annual interest and principal payments on a country’s external debts.
In personal finance, it is a ratio utilized by bank credit officers to find out income for property loans.
This ratio is well thought-out to be ideal if it is more than 1 thus signifying that the property is producing income that is sufficient to repay its taken or to be taken loan.
In every case, the ratio reflects the capability to service debt given a meticulous level of income. It has different interpretations in different line of activity.
Why is the DSCR important?
The DSCR ratio indicates the financial health of a company. A lower ratio indicates an increased probability of default or bankruptcy. However, a low ratio does not necessarily mean the company is at risk.
A company’s DSCR should be compared to the DSCR of other companies operating in the same industry, and evaluated relative to the industry average.
It would be inappropriate to compare an airline company (using large amounts of debt) with a software company (which likely uses more equity financing).
Advantage of Debt Service Coverage Ratio
- DSCR measures the cash flow ready to pay its current debt obligations.
- It is used to analyse debt service of firms, projects, or individual borrowers.
- The minimum DSCR would be depended upon the demand raised by a lender as whole.
- Lenders may be more forgiving of lower ratios when their economy is growing, .
- DSCR helps the lender to determine whether your business can eligible to take the small business loan or not.
Disadvantage of Debt Service Coverage Ratio
- Below one indicates a negative cash flow. In such a case, lenders refrain from offering a loan
Formula of Debt Service Coverage Ratio
DSCR = Net Operating Income/Total Debt Service
Where Net Operating Income includes Net Income (PAT) + Interest + Non cash Expense + Tax
Total Debt Service includes Interest + Principal Repayments + Lease Payments
Net Operating income is a “Pre-tax number.
Broadly we can say,
DSCR = (Net Income + Interest + Non cash Expense + Tax) / (Interest + Principal Repayments + Lease Payments)
Analysis and Interpretation of Debt Service Coverage Ratio
Just doing calculation of this ratio is not serve the purpose properly till it is analyzed and interpreted accurately. The result of a debt service coverage ratio is an absolute figure for bankers and investors.
When the value of this is high means better debt serving capacity of a firm. It shows sound financial condition of the firm.
If the value of this ratio is less than 1, it is considered bad because it simply indicates that the liquid condition of the firms are not sufficient to service its debt obligations.
That means, it directly indicates negative views about the repayment capacity of the firm.
When DSCR is above 1 means your business has good income to pay its debts. It acts as a cushion even if there is some fluctuation in the business’ cash flow.
For example, a DSCR of 1.25 means that your business makes 25 % more income than it needs to cover its debts.
When DSCR is equal to 1 means all of your business’ net income is going to paying debts equally. While this is better than having a negative cash flow.
When DSCR is below 1 means your business is not creating enough earnings to pay its debts.
For example, if your DSCR is .95, means you do not have enough income to pay your debts. Only you are able to pay 95% of debts and rest 5% will be paid from your other personal source of earnings.
Sometimes, this negative value of this ratio would resist you by the lender while you approach for loans. A good business would be able to sustain itself without resort to personal income to repay.
The standard industry norm is for debt service coverage ratio from 1.5 to 2. This ratio is of very useful to lenders of money like banks, financial institutions etc.
Objectives of any financial institution behind giving a loan to a business is earning interest and to make sure that principal amount remains secured.
Example of Debt Service Coverage Ratio
Let’s take an example of a company is looking to remodel its storefront, but it doesn’t have enough cash to pay for the remodel itself.
Thus, company is talking with several banks in order to get a loan. Company is a little worried that he won’t get a loan because he already has several loans.
According to his financial statements and documents, Company’s had the following:
|Net Operating Profits||$150,000|
|Sinking Fund Obligations||$25,000|
Here is company’s debt service coverage calculation:
DSCR = $150000/ ($55000 + $35000 + $25000)
= $150000 / $115000
As you can see, Company has a ratio of 1.3. This means that Company makes enough in operating profits to pay its current debt service amount. After paying all debts amount is left with 30 percent of his profits.