What is Debt Service Coverage Ratio?
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. DSCR is often used when a company has any borrowings on its balance sheet such as bonds, loans and 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 the debt service coverage ratio:
- EBITDA = Earnings Before Interest, Tax, Depreciation and Amortization
- Principle represents the total amount of short-term and long-term borrowings
- Interest represents 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 a short-term debt of $5,000 and a long-term debt of $12,000. The interest rate on short-term debt is 3.5% and the interest rate on long-term debt is 5.0%. The company’s 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 debt service coverage ratio:
Debt service coverage (includes Capex) = 29,760 / (5,000 x (1 + 3.5%) + 12,000 x (1 + 5.0%)) = 1.7x
Debt service coverage (excludes Capex) = (29,760 – 4,900) / (5,000 x (1 + 3.5%) + 12,000 x (1 + 5.0%)) = 1.4x
Therefore, 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 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 debt service coverage ratio should be 2 or higher. It suggests the company is capable of taking on more debt.
A DSCR of less than 1 is not optimal because it reflects the company’s inability to serve its current debt obligation. For example, DSCR of 0.8 indicates that there is only enough operating income to cover 80% of the company’s debt payment.
Common Uses of Debt Service Coverage Ratio
- DSCR is a common benchmark to measure the ability of a company to pay its outstanding debt including principle 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.