Debt Service Coverage Ratio

What is the Debt Service Coverage Ratio?

The Debt Service Coverage Ratio (DSCR) measures the ability of a company to use its 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 to repay all its debt obligations, including repayment of principal and interest on both short-term and long-term debtLong Term DebtLong Term Debt (LTD) is any amount of outstanding debt a company holds that has a maturity of 12 months or longer. It is classified as a non-current liability on the company’s balance sheet. The time to maturity for LTD can range anywhere from 12 months to 30+ years and the types of debt can include bonds, mortgages. This ratio is often used when a company has any borrowings on its balance sheetBalance SheetThe balance sheet is one of the three fundamental financial statements. These statements are key to both financial modeling and accounting. The balance sheet displays the company’s total assets, and how these assets are financed, through either debt or equity. Assets = Liabilities + Equity such as bondsBondsBonds are fixed-income securities that are issued by corporations and governments to raise capital. The bond issuer borrows capital from the bondholder and makes fixed payments to them at a fixed (or variable) interest rate for a specified period., loans, or lines of credit. It is also a commonly used ratio in a leveraged buyoutLeveraged Buyout (LBO)A leveraged buyout (LBO) is a transaction where a business is acquired using debt as the main source of consideration. An LBO transaction typically occur when a private equity (PE) firm borrows as much as they can from a variety of lenders (up to 70-80% of the purchase price) to achieve an internal rate return IRR >20% transaction, to evaluate the debt capacity of the target company, along with other credit metrics such as total debt/EBITDADebt/EBITDA RatioThe net debt to earnings before interest, taxes, depreciation, and amortization (EBITDA) ratio measures financial leverage and a company’s ability to pay off its debt. Essentially, the net debt to EBITDA ratio (debt/EBITDA) gives an indication as to how long a company would need to operate at its current level to pay off all its debt. multiple, net debt/EBITDA multiple, interest coverage ratio,Interest 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. and fixed charge coverage ratioFixed-Charge Coverage Ratio (FCCR)The Fixed-Charge Coverage Ratio (FCCR) is a measure of a company’s ability to meet fixed-charge obligations such as interest and lease expenses..

Debt Service Coverage Ratio Formula

There are two ways to calculate this ratio:

Where:

• EBITDAEBITDAEBITDA or Earnings Before Interest, Tax, Depreciation, Amortization is a company's profits before any of these net deductions are made. EBITDA focuses on the operating decisions of a business because it looks at the business’ profitability from core operations before the impact of capital structure. Formula, examples = Earnings Before Interest, Tax, Depreciation, and Amortization
• Principal = the total loan amount of short-term and long-term borrowings
• Interest = the interest payable on any borrowings
• CapexCapital ExpenditureA Capital Expenditure (Capex for short) is the payment with either cash or credit to purchase goods or services that are capitalized on the balance sheet. Put another way, it is an expenditure that is capitalized (i.e., not expensed directly on the income statement) and is considered an "investment". Analysts view Capex = Capital Expenditure

Some companies might prefer to use the latter formula because capital expenditure is not expensed on the income statementIncome StatementThe Income Statement is one of a company's core financial statements that shows their profit and loss over a period of time. The profit or loss is determined by taking all revenues and subtracting all expenses from both operating and non-operating activities.This statement is one of three statements used in both corporate finance (including financial modeling) and accounting. but rather considered as an “investment”. Excluding CAPEX from EBITDA will give the company the actual amount of operating income available for debt repayment.

Debt Service Coverage Ratio Example

Consider a company which has short-term debt of $5,000 and long-term debt of $12,000. The interest rate on the short-term debt is 3.5% and the interest rate on the long-term debt is 5.0%. Capital expenditure in 2018 is $4,900.

The company’s income statement is as follows:

We can use the two formulas to calculate the ratio:

Debt service coverage ratio (including Capex) = 29,760 / (5,000 x (1 + 3.5%) + 12,000 x (1 + 5.0%)) = 1.7x

Debt service coverage ratio (excluding Capex) = (29,760 – 4,900) / (5,000 x (1 + 3.5%) + 12,000 x (1 + 5.0%)) = 1.4x

Thus, the ratio shows the company can repay its debt service 1.7 times with its operating income and 1.4 times with its operating income, less capex.

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Interpretation of the Debt Service Coverage Ratio

A debt service coverage ratio of 1 or above indicates that a company is generating sufficient operating income to cover its annual debt and interest payments. As a general rule of thumb, an ideal ratio is 2 or higher. A ratio that high suggests that the company is capable of taking on more debt.

A ratio of less than 1 is not optimal because it reflects the company’s inability to service its current debt obligations with operating income alone. For example, a DSCR of 0.8 indicates that there is only enough operating income to cover 80% of the company’s debt payments.

Rather than just looking at an isolated number, it is better to consider a company’s debt service coverage ratio relative to the ratio of other companies in the same sector. If a company has a significantly higher DSCR than most of its competitors, that indicates superior debt management. A financial analyst may also want to look at a company’s ratio over time – to see whether it is trending upward (improving) or downward (getting worse).

Common Uses of the Debt Service Coverage Ratio

• The debt service coverage ratio is a common benchmark to measure the ability of a company to pay its outstanding debt including principal and interest expense.
• DSCR is used by an acquiring company in a leveraged buyoutLeveraged Buyout (LBO)A leveraged buyout (LBO) is a transaction where a business is acquired using debt as the main source of consideration. An LBO transaction typically occur when a private equity (PE) firm borrows as much as they can from a variety of lenders (up to 70-80% of the purchase price) to achieve an internal rate return IRR >20% to assess the target company’s debt structure and ability to meet debt obligations.
• DSCR is used by bank loan officers to determine the debt servicing ability of a company.

Additional Resources

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