The Debt Service Coverage Ratio (DSCR) is used to estimate whether the company is capable of covering its debt-related obligations with the net operating income it generates . In simple words, it measures the relationship between the business’s income and its debt.
This ratio is often used when a company has any borrowings on its balance sheet such as bonds, loans, or lines of credit.
IMPORTANCE OF DEBT SERVICE COVERAGE RATIO
The debt service coverage ratio is a good way to monitor the business’s health and financial success.
It is used as a benchmark by lenders and creditors to measure the cash-producing ability of a business entity to cover its debt payments. It is one of the main indicators lenders look at when evaluating the loan application.
HOW TO CALCULATE DSCR ?
The Debt service coverage ratio is calculated by using the formula :-
Debt Service Coverage Ratio= Net Operating Income/ Debt Service
Net Operating Income is referred as the business’s EBITDA i.e. (earnings before interest, taxes, depreciation, and amortization)
Total Debt service = Interest + Principal Repayments + Lease Payments
WHY DEPRECIATION IS ADDED TO INCOMES ?
Now , in this formula while calculating net operating income the tax amount is added back to the net income because interest payment comes prior to tax payers for the company therefore, the cash in hand before interest payment will first be used to pay the interest and then only to pay the tax.
Similarly, depreciation and amortization expenses are also added back to the net income since these are non cash expenses which implies that there isn’t any cash outflow . Hence that amount of cash can be used by the company to meet their debt obligations .
A high DSCR indicates a favourable financial position of the company which implies that the business generates enough income to manage payments on a new loan and still make a profit.
Whereas , a DSCR below 1 indicates a negative cash flow. In such a case, lenders refrain from offering a loan, unless the borrower has a sound income.
Thus, in a nutshell, the Debt Service Coverage Ratio (DSCR) is an accounting ratio that measures the ability of a business to cover its debt payments & is used most frequently by lending institutions to determine how able a business is to repay current debt and take on more.