How to Calculate Debt Service Coverage Ratio
Step-by-Step Solution to Examples
How to Calculate the Debt Service Coverage Ratio
This guide will describe how to calculate the Debt Service Coverage Ratio. 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 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 pay off their debt obligations.
Why is the DSCR important?
The DSCR ratio indicates the financial health of an entity. Using the formula may highlight the likelihood of a firm about to file for bankruptcy if they have a low ratio (i.e., struggling to pay back their creditors). A low ratio does not necessarily imply that the company is risky, as companies should be compared within a certain sector or industry. It would be inappropriate to compare an airline company (using large amounts of debt) with a software company (which may use a small portion of debt).
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 is it 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 principal 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 as well as make their interest payments.
Debt Service = Interest 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 Expense (since these values are not provided).
Sales = 3 x Cost of Goods Sold
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)
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: