What is the Debt Service Coverage Ratio?
The Debt 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. This ratio is often used when a company has any borrowings on its balance sheet such as bonds, loans, or lines of credit. It is also a commonly used ratio in a leveraged buyout transaction, to evaluate the debt capacity of the target company, along with other credit metrics such as total debt/EBITDA multiple, net debt/EBITDA multiple, interest coverage ratio and fixed charge coverage ratio.
Debt Service Coverage Ratio Formula
There are two ways to calculate this ratio:
- EBITDA = 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
- Capex = Capital Expenditure
Some companies might prefer to use the latter formula because capital expenditure is not expensed on the income statement 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:
|Marketing and Promotion Expense||14,800|
|General and Administrative Expense||6,310|
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 should be 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 buyout 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.
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