What is debt service coverage ratio (DSCR)? Definition and meaning
DSCR, which stands for debt service coverage ratio, is the ratio of cash available for debt servicing to interest, principal and lease payments. In other words, it measures a business’ ability to service its current debts by comparing its net operating income with its total debt service obligations.
Debt equity coverage ratio, unlike the debt ratio, takes into account all expenses related to debt including interest expense plus other obligations such as pension and sinking fund obligations. The DCSR tells us much more about an entity’s ability to pay its debt than the debt ratio does. An entity refers to any company or organization that pays taxes and makes a profit/loss.
In Government finance, the debt-service coverage ratio refers to the amount of export earnings required to pay the country’s annual interest and principal payments on its external debts.
DSCR in corporate finance is a measure of the cash flow available to pay current debt obligations. In government finance, it is the amount of export earnings required to meet annual interest and principal payments on a nation’s external debts.
Also known as debt coverage ratio, it is a popular standard used in the measurement of a person’s or company’s ability to produce enough liquid cash to meet their debt payments, including lease payments.
According to Divestopedia, debt service coverage ratio is:
“The amount of cash available to service debt in the form of interest, principal and sinking fund payments. It is used to determine if a firm has enough cash to cover its debt. The ratio is calculated as total net operating income divided by total debt serviced.”
Likelihood of obtaining a loan
An entity with a high debt service coverage ratio will find it easier to get a loan compared to one with a low DSCR.
In commercial banking, the term is also used to express the minimum ratio that is acceptable to a money lender – it could be a loan condition. In some cases breaching a DSCR covenant could be seen as an act of default.
The DSCR is important to both investors and creditors – creditors analyze it more often. Current and potential creditors are particularly interested in an entity’s DSCR since the ratio measures its ability to meet its current debt obligations.
Creditors and potential creditors want to know what a company’s cash position is, its cash flow, as well as how much debt it currently owes and the amount of cash it has available to pay its current and future debt.
Debt service coverage ratio formula
We calculate the DSR by dividing net operating income by total debt service.
Net operating income equals all cash flows that are left after paying off all operating expenses, which is sometimes known as EBIT (earnings before interest & taxes).
Total debt service refers to all the costs incurred to service an entity’s debt, which generally includes principle payments, interest payments and other obligations.
Example of DSCR
John Doe Electrics is a store that wants to remodel its storefront. However, it does not have enough money available to pay for it. It has approached some banks in order to get a loan.
As it already has several loans, the store is a bit worried it won’t be able to borrow any more.
John Doe’s’ financial statement showed the following figures:
– Net Operating Profits: $200,000
– Interest Expense: $60,000
– Principal Payments: $40,000
– Sinking Fund Obligations: $30,000
The calculation for John Doe’s debt service coverage is:
Debt Service Coverage Ratio = 200,000 ÷ (60,000 + 40,000 + 30,000) = 1.66
Therefore, John Doe’s DSCR = 1.66. See the breakdown of the figures in the image below.
This means that John Doe’s operating profits provide enough to pay its current debt service costs and be left with 66% of its profits. Banks are likely to view its loan application favorably (depending on how much it needs to borrow).
Video – What is Debt Service Coverage Ratio?
The DSCR is a measurement that tells us how much cash flow is available to service an entity’s debt. It helps banks evaluate a loan applicant’s creditworthiness.