Debt Service Coverage Ratio in detail

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​

 

Where,

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.

 

 

Accounting & Finance for Banking

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