Updated: Sep 13
The debt-service coverage ratio applies to corporate, government, and personal finance. In the context of corporate finance, the debt-service coverage ratio (DSCR) is a measurement of a firm's available cash flow to pay current debt obligations. The DSCR shows investors whether a company has enough income to pay its debts.
Understanding Debt-Service Coverage Ratio (DSCR)
The debt-service coverage ratio is a widely used indicator of a company's financial health, especially those who are highly levered and carrying a lot of debt. The ratio compares a company's total debt obligations (including principal repayments and some capital lease agreements) to its operating income.
Different lenders, stakeholders, and partners will target different DSCR metrics. In addition, a company's history, industry, product pipeline, and prior relationships with lenders. External parties may also be more considerate during seasonal operations when a company's income is flexible, though DSCR terms are often included in loan agreements.
DSCR Formula and Calculation
The formula for the debt-service coverage ratio requires net operating income and the total debt servicing for the entity. Net operating income is a company's revenue minus certain operating expenses (COE), not including taxes and interest payments. It is often considered the equivalent of earnings before interest and tax (EBIT).
Some calculations include non-operating income in EBIT. As a lender or investor comparing different companies' creditworthiness—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.
Calculating DSCR Using Excel
To create a dynamic DSCR formula in Excel, you cannot simply run an equation that divides net operating income by debt service. Rather, you would title two successive cells, such as A2 and A3, "net operating income" and "debt service." Then, adjacent to those cells, in B2 and B3, you would place the respective figures from the income statement.
In a separate cell, enter a formula for DSCR that uses the B2 and B3 cells rather than actual numeric values (e.g., B2 / B3).
Even for a calculation this simple, it is best to use a dynamic formula that can be adjusted and recalculated automatically. One of the primary reasons to calculate DSCR is to compare it to other firms in the industry, and these comparisons are easier to run if you can simply plug in the numbers.
What DSCR Can Tell You?
Whether the context is corporate finance, government finance, or personal finance, the debt-service coverage ratio reflects the ability to service debt given a particular level of income. The ratio states net operating income as a multiple of debt obligations due within one year, including interest, principal, sinking funds, and lease payments.
In the context of government finance, the DSCR is the number of export earnings needed by a country to meet annual interest and principal payments on its external debt. In the context of personal finance, it is a ratio used by bank loan officers to determine income property loans.
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 tendency to lend to less-qualified borrowers can, in turn, affect the economy's stability.
This was arguably the case leading up to the 2008 financial crisis. Subprime borrowers were able to obtain credit, particularly mortgages, with little scrutiny. When these borrowers began to default en masse, the financial institutions that had financed them collapsed.
Evaluating DSCR Outcomes
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—in essence, borrowing more.
For example, a DSCR of 0.95 means that there is only sufficient 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 their personal funds every month to keep the project afloat. In general, lenders frown on negative cash flow, but some allow it if the borrower has strong resources in addition to their income.
If the debt-service coverage ratio is too close to 1, for example, 1.1, the entity is vulnerable, and a minor decline in cash flow could render 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 an individual, company, or government—has sufficient income to pay its current debt obligations.
Interest Coverage Ratio vs. DSCR
The interest coverage ratio indicates the number of times that a company's operating profit will cover the interest it must pay on all debts for a given period. This is expressed as a ratio and is most often computed on an annual basis.
To calculate the interest coverage ratio, simply divide the EBIT for the established period by the total interest payments due for that same period. The EBIT, often called net operating income or operating profit, is calculated by subtracting overhead and operating expenses, such as rent, cost of goods, freight, wages, and utilities, from revenue. This number reflects the amount of cash available after subtracting all expenses necessary to keep the business running.
The higher the EBIT to interest payments ratio, the more financially stable the company. This metric only considers interest payments and not payments made on principal debt balances that may be required by lenders.
The debt-service coverage ratio is slightly more comprehensive. This metric assesses a company's ability to meet its minimum principal and interest payments, including sinking fund payments, for a given period. To calculate DSCR, EBIT is divided by the total amount of principal and interest payments required for a given period to obtain net operating income. Because it takes into account principal payments in addition to interest, the DSCR is a slightly more robust indicator of a company's financial fitness.
In either case, a company with a debt-service coverage ratio of less than 1.00 does not generate enough revenue to cover its minimum debt expenses. In terms of business management or investment, this represents a risky prospect since even a brief period of lower-than-average income could spell disaster.
Advantages of DSCR
DSCR, like other ratios, have value when calculated consistently over time. A company can calculate monthly DSCR to analyze its average trend over a period of time and project future ratios. For example, a declining DSCR may be an early signal for a decline in a company's financial health. Alternatively, it can be used extensively in the budgeting or strategic planning process.
DSCR may also have comparability across different companies. Management may use DSCR calculations from its competitors to analyze how it is performing relative to others, including analyzing how efficient other companies may be in using loans to drive company growth.
DSCR is also a more comprehensive analytical technique when assessing the long-term financial health of a company. Compared to the interest coverage ratio, DSCR is a more conservative, broad calculation. DSCR is also an annualized ratio that often represents a moving 12-month period. Other financial ratios are usually a single snapshot of a company's health; therefore, DSCR may be a more true representation of a company's operations.
Disadvantages of DSCR
The DSCR calculation may be adjusted to be based on net operating income, EBIT, or EBITDA (depending on the lender's requirement). If operating income, EBIT, or EBITDA are used, the company's income is potentially overstated because not all expenses are being considered. For example, in all three examples, income is not inclusive of taxes.
Another limitation of DSCR is its reliance on accounting guidance. Though debt and loans are rooted in obligatory cash payments, DSCR is partially calculated on accrual-based accounting guidance. Therefore, there is a little bit of inconsistency when reviewing both a set of GAAP-based financial statements and a loan agreement that stipulates fixed cash payments.
Example of DSCR
Let's say a real estate developer is looking to obtain a mortgage loan from a local bank. The lender will want to calculate the DSCR to determine the ability of the developer to borrow and pay off their loan as the rental properties they build generate income.
The developer indicates that net operating income will be $2,150,000 per year, and the lender notes that debt service will be $350,000 per year. The DSCR is calculated as 6.14x, which should mean the borrower can cover their debt service more than six times given their operating income.
How Do You Calculate the Debt Service Coverage Ratio (DSCR)?
The DSCR is calculated by dividing net operating income by total debt service (which includes the principal and interest payments on a loan). For example, if a business has a net operating income of $100,000 and a total debt service of $60,000, its DSCR would be approximately 1.67.
Why Is the DSCR Important?
DSCR is a commonly used metric when negotiating loan contracts between companies and banks. For instance, a business applying for a line of credit might be obligated to ensure that its DSCR does not dip below 1.25. If it does, the borrower could be found to have defaulted on the loan. In addition to helping banks manage their risks, DSCRs can also help analysts and investors when analyzing a company’s financial strength.
What Is a Good DSCR?
A “good” DSCR depends on the company’s industry, competitors, and stage of growth. For instance, a smaller company that is just beginning to generate cash flow might face lower DSCR expectations compared to a mature company that is already well established. As a general rule, however, a DSCR above 1.25 is often considered “strong,” whereas ratios below 1.00 could indicate that the company is facing financial difficulties.