Debt Service Coverage Ratio in detail

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

Where.

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.

Accounting & Finance for Banking

Principles & Practices of Banking Module E Pdf

Free
Module E PPB ePDFs available in our android app. Get them all at https://iibf.info/app

Accounting and Finance for Banking Module A Pdf

Free
Accounting and finance for bankers all ePDFs are available in our an app. Get them all at https://iibf.info/app

Accounting and Finance for Banking Module A Pdf

Free
Accounting and finance for bankers all ePDFs are available in our an app. Get them all at https://iibf.info/app

Leave a reply

Please enter your comment!
Please enter your name here

Popular

Free Live Classes

spot_img

More from author

All about KYC/AML Exam by IIBF

All about KYC/AML Exam by IIBF The KYC/AML is a professional certification exam in Anti Money Laundering and Know your customer conducted by the Indian...

CCP- Certified Credit Professional Course by IIBF

IIBF CCP (Certified Credit Professional) exam is an All-India Exam directed by the Indian Institute of Banking and Finance (IIBF) to select competent candidates...

What is Digital Banking in Detail

Digital Banking is the automation of traditional banking services. It is defined as banking done through the digital platform, doing away with all the...

Digital Banking Course By IIBF

Digital Banking Course By IIBF Certificate course in Digital Banking is conducted by IIBF to provide practicing bankers a sound foundation in the digital banking...