# Debt Service Coverage Ratio in detail

The Debt Service Coverage Ratio (DSCR) is an important measure in understanding a borrowerâ€™s abilityÂ to fulfill his financial obligations.

In other words, it is a measure of the cash flow available to pay current debt obligations.

It is mainly used by lenders to determine if the business generates enough income toÂ afford a business loan & is used to analyze firms, projects, or individual borrowers.

#### IMPORTANCE OF DEBT SERVICE COVERAGE RATIO :-

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This ratio is important because of the following reasons â€“

• It is a good way to monitor the businessâ€™s health and financial success.
• This ratio measures a firmâ€™s ability to maintain its current debt levels.Â
• It compares a companyâ€™s available cash with its current interest, principle, and sinking fund obligations.
• DSCR is used by bank loan officers to determine the debt servicing ability of a company.

#### CALCULATION OF DEBT SERVICE COVERAGE RATIO :-

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The formula for this ratio is â€“

Debt Coverage Ratio =

Â  Â  Â  Â  Â  Â  Â  Â  Â  Net Operating Income / Annual Debt Paymentsâ€‹

Â

Where,

Net operating income = Total revenue or income generated from selling products or services, minus operating expenses.Â It is also referred as EBIT (earnings before interest and taxes)

Annual debt payments = Â Total amount of debt payments due in the upcoming year. It includes Â both short-term and long-term debt, as well as any potential new loan payments.

#### INTERPRETATION OF RATIO :-

Â The debt service coverage ratio measures a firmâ€™s ability to maintain its current debt levels. This is why a higher ratio is always more favorable than a lower ratio. A higher ratio indicates that there is more income available to pay for debt servicing.

A ratio of 1 or above indicates that a company is earning sufficient operating income to repay its annual debt & other financial obligations . Generally,Â  an ideal ratio is 2 or higher.

Similarly, a ratio of less than 1 indicates the companyâ€™s inability to repay its annual debt and other interest payments. Hence, it is not favourable.

Thus, in simple words, Debt Coverage Ratio Â is a measurement of a companyâ€™s cash flow and how it could be used toÂ meet the debt expectations over the course of one year.

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