The Debt Service Coverage Ratio (DSCR) is an important measure in understanding a borrower’s ability 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 to afford a business loan & is used to analyze firms, projects, or individual borrowers.
IMPORTANCE OF DEBT SERVICE COVERAGE RATIO :-
This ratio is important because of the following reasons –
- It is a good way to monitor the business’s health and financial success.
- This ratio measures a firm’s ability to maintain its current debt levels.
- It compares a company’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 :-
The formula for this ratio is –
Debt Coverage Ratio =
Net Operating Income / Annual Debt Payments
Net operating income = Total revenue or income generated from selling products or services, minus operating expenses. It is also referred as EBIT (earnings before interest and taxes)
Annual debt payments = Total amount of debt payments due in the upcoming year. It includes both short-term and long-term debt, as well as any potential new loan payments.
INTERPRETATION OF RATIO :-
The debt service coverage ratio measures a firm’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, an ideal ratio is 2 or higher.
Similarly, a ratio of less than 1 indicates the company’s inability to repay its annual debt and other interest payments. Hence, it is not favourable.
Thus, in simple words, Debt Coverage Ratio is a measurement of a company’s cash flow and how it could be used to meet the debt expectations over the course of one year.