How to Calculate Debt Service Coverage Ratio

How to Calculate the Debt Service Coverage Ratio

This guide will describe how to calculate the Debt Service Coverage RatioDebt Service Coverage RatioDebt Service Coverage Ratio (DSCR) measures the ability of a company to use its operating income to repay all its debt obligations, including repayment of principal and interest on both short-term and long-term debt. DSCR is often used when a company has any borrowings on its balance sheet such as bonds, loans and line. First, we will go over a brief description of the Debt Service Coverage Ratio, why it is important, and then go over step-by-step solutions to several examples of Debt Service Coverage Ratio Calculations.

What is the Debt Service Coverage Ratio (DSCR)?

This ratio measures the net operating incomeOperating IncomeOperating Income, also referred to as operating profit or Earnings Before Interest & Taxes (EBIT), is the amount of revenue left after deducting operational direct and indirect costs. Interest expense, interest income, and other non-operational revenue sources are not considered in computing operating income available to pay short-term debt. The DSCR is a useful benchmark to measure an individual or firm’s ability to meet their debt payments with cash. A higher ratio implies that the entity is more creditworthy because they have sufficient funds to service their debt obligations – to make the required payments on a timely basis.

Why is the DSCR important?

The DSCR ratio indicates the financial health of an entity. A lower ratio indicates an increased probability of default or bankruptcyBankruptcyBankruptcy is the legal status of a human or a non-human entity (a firm or a government agency) that is unable to repay its outstanding debts to creditors. Generally, it is initiated by the debtor and imposed by a court. 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).

Example 1 – DSCR Income Statement

In this example, we will calculate the Debt Service Coverage Ratio of Company A. Use the following income statement:

Answer

Step 1: Write out the formula

DSCR = Net Operating Income / Debt Service

Step 2: Find the Net Operating Income

The operating income is found by subtracting the operating expenses from the firm’s gross profit. In this example, it is equal to $600M.

Step 3: Find the Debt Service

The debt service will typically be located below the operating income, as the entity must pay their interest and principalPrincipal Definition payments before tax. Debt service is just the interest expense in this example, which is equal to $200M.

Step 4: Calculate to find the DSCR

DSCR = Net Operating Income / Debt Service

DSCR = $600M / $200M = 3 (or 3x as it’s a ratio)

Example 2 – DSCR Simple Income Statement

In this example, we will calculate the Debt Service Coverage Ratio of Company B. Use the following income statement:

Answer

Step 1: Write out the formula

DSCR = Net Operating Income / Debt Service

Step 2: Find the Net Operating Income

The operating income is located below the operating expenses (SG&A and R&D expenses). It is equal to $300M in this example.

Step 3: Find the Debt Service

In this example, the debt service is larger because the firm must pay back principal plus interest payments.

Debt Service = InterestInterest ExpenseInterest expense arises out of a company that finances through debt or capital leases. Interest is found in the income statement, but can also be calculated through the debt schedule. The schedule should outline all the major pieces of debt a company has on its balance sheet, and calculate interest by multiplying the and Lease Payments + Principal Repayment

Debt Service = $50M + $150M = $200M

Step 4: Calculate to find the DSCR

DSCR = Net Operating Income / Debt Service

DSCR = $300M / $200M = 1.5 (or 1.5x)

Example 3 – Missing Elements from Income Statement

In this example, we will calculate the Debt Service Coverage Ratio of Company C. Use the following income statement and information:

Information:

• R&D Expense is 25% of the firm’s SG&A Expense.
• Principal Payments and Interest Expense are each 10% of the firm’s Operating Income.
• Sales are three times the company’s Cost of Goods Sold.

Answer

Step 1: Write out the formula

DSCR = Net Operating Income / Debt Service

Step 2: Find the Net Operating Income

To figure out the firm’s Net Operating Income, we must calculate the Sales and R&D ExpenseResearch and Development (R&D)Research and Development (R&D) is a process by which a company obtains new knowledge and works on the introduction and improvement of its products and (since these values are not provided).

Sales = 3 x Cost of Goods SoldCost of Goods Sold (COGS)Cost of Goods Sold (COGS) measures the “direct cost” incurred in the production of any goods or services. It includes material cost, direct labor cost, and direct factory overheads, and is directly proportional to revenue. As revenue increases, more resources are required to produce the goods or service. COGS is often

Sales = 3 x $400M = $1200M

R&D Expense = 25% x SG&A Expense

R&D Expense = 25% x $200M = $50M

Net Operating Income = Sales – Cost of Goods Sold – SG&A Expense – R&D Expense

Net Operating Income = $1200M – $400M – $200M – $50M = $550M

Step 3: Find the Debt Service

Principal Payments and Interest Expense are each 10% of the company’s Operating Income:

Principal Payments = 10% x Operating Income

Principal Payments = 10% x $550M = $55M

Interest Expense = 10% x Operating Income

Interest Expense = 10% x $550M = $55M

Now find the Debt Service:

Debt Service = Interest & Lease Payments + Principal Repayment

Debt Service = $55M + $55M = $110M

Step 4: Calculate to find the DSCR

DSCR = Net Operating Income / Debt Service

DSCR = $550M / $110M = 5 (or 5x)

Example 4 – DSCR + Fill out Income Statement

In this example, we will calculate the Debt Service Coverage Ratio of Company D. Use the following partial income statement and information:

Information:

• Tax rate is 50%.
• R&D Expense is $10M less than half of the firm’s SG&A Expense.
• Principal Payments are double the Pre-Tax Profit.
• Cost of Goods Sold is 60% of Sales.
• Net Income is 25% of the Lease Payments.
• SG&A Expense is 30% of the company’s Sales.
• Lease Payments are double the Interest Expense.

Answer

Step 1: Write out the formula

DSCR = Net Operating Income / Debt Service

Step 2: Fill out the income statement

To find the firm’s Net Operating Income, since most line items are blank, we must first fill out the income statement with the information we have:

• Lease Payments

Starting with the Interest Expense of $20M (the only value we have), we can figure out the Lease Payments since they are double the Interest Expense.

Lease Payments = 2 x $20M = $40M

• Net Income

We can now figure out the Net Income (because it is 25% of the Lease Payments).

Net Income = 25% x $40M = $10M

• Pre-Tax Profit & Tax Expense

The 50% tax rate implies that the tax expense is 50% of the Pre-Tax Profit. The firm keeps 50% of the Pre-Tax Profit as Net Income. Therefore, we can conclude that the Pre-Tax Profit is double the Net Income.

Pre-Tax Profit = 2 x $10M = $20M

Tax Expense = Pre-Tax Profit – Net Income

Tax Expense = $20M – $10M = $10M

• Principal Payments

Principal Payments are double the Pre-Tax Profit

Principal Payments = 2 x Pre-Tax Profit

Principal Payments = 2 x $20M = $40M

• Operating Income

Although Operating Income is missing, we can calculate this by adding the line items that we have values for, above the Pre-Tax Profit.

Operating Income = Pre-Tax Profit + Interest Expense + Lease Payments + Principal Payments

Operating Income = $20M + $20M + $40M + $40M = $120M

Step 3: Find the Debt Service

Debt Service = Interest & Lease Payments + Principal Repayment

Debt Service = $20M + $40M + $40M = $100M

Step 4: Calculate to find the DSCR

DSCR = Net Operating Income / Debt Service

DSCR = $120M / $100M = 1.2 (or 1.2x)

Final Word

The Debt Service Coverage Ratio can be a very helpful metric for assessing a company’s overall financial health, and specifically how capable it is of servicing its current debt. The ratio can also assist lenders and investors in determining whether it’s safe for the company to take on additional debt financing. The DSCR should always be looked at relative to the industry average.

Additional Resources

The Debt Service Coverage Ratio is an important metric for management and Financial Analysis. To learn more, check out CFI’s Financial Analysis Fundamentals. Here are a few other resources that are related to DSCR:

• Interest Coverage RatioInterest Coverage RatioInterest Coverage Ratio (ICR) is a financial ratio that is used to determine the ability of a company to pay the interest on its outstanding debt. The ICR is commonly used by lenders, creditors, and investors to determine the riskiness of lending capital to a company. The interest coverage ratio is also called “times
• Capital vs Operating LeaseCapital Lease vs Operating LeaseThe difference between a capital lease vs operating lease is a relatively advanced concept and is unlikely to come up in entry-level finance interviews. However, it is useful to understand the difference between the two types of leases and their respective accounting treatment. Capital leases are counted as debt. They
• Profit and Loss Statment (P&L)Profit and Loss Statement (P&L)A profit and loss statement (P&L) is a financial report that provides a summary of a company's revenues, expenses, and profits/losses over a period of time
• Coverage RatioCoverage RatioA Coverage Ratio is used to measure a company’s ability to pay its financial obligations. A higher ratio indicates a greater ability of the company to meet its financial obligations while a lower ratio indicates a lesser ability. Learn Interest Coverage, Debt Service, Cash Coverage, and Asset Coverage ratios, examples