Debt Service Coverage Ratio

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What is the Debt Service Coverage Ratio (DSCR)?

The Debt Service Coverage Ratio (DSCR) is a financial ratio that assesses how well a business can use its operating cash flow to pay down its outstanding debt. It is computed as the difference between the total debt service (principal and interest payments included) and net operating income (NOI). 

If a company's debt-to-cash ratio (DSCR) is higher, it means it has enough cash flow to pay off its debts; if it's lower, it might find it difficult to make ends meet or might have to take on more debt.

Why is Debt Service Coverage Ratio (DSCR) important?

The Debt Service Coverage Ratio (DSCR), which indicates a company's trustworthiness and financial health, is significant information for both lenders and borrowers. Lenders utilize DSCR to calculate the interest rate and loan terms, as well as to assess the risk of providing money to a certain company.

A lower DSCR indicates a greater likelihood of default or the necessity for debt restructuring, whereas a higher DSCR indicates a reduced likelihood of default on debt payments. For commercial loans, lenders usually demand a minimum debt-to-income ratio (DSCR) of 1.25x or above, which means that the business's NOI must be at least 25% greater than its total debt payment.

Borrowers arrange their capital structure and evaluate their own loan capacity using the DSCR. A lower DSCR indicates that the company may need to increase profitability or reduce debt, whereas a higher DSCR indicates that the company has greater financial flexibility and may afford to invest in growth possibilities or take on more debt.

Additionally, borrowers utilize DSCR to bargain with lenders for better loan conditions and to examine various financing possibilities.

What is the formula for Debt Service Coverage Ratio (DSCR)?

The formula for Debt Service Coverage Ratio (DSCR) is:

DSCR = Net Operating Income / Total Debt Service

where:

• Net Operating Income (NOI) is the company's revenue minus certain operating expenses, such as cost of goods sold, selling, general and administrative expenses, depreciation, and amortization. It is often considered equal to earnings before interest and taxes (EBIT).
• Total Debt Service (TDS) is the sum of all principal and interest payments due in a given period, usually one year. It includes both short-term and long-term debt obligations.

Nevertheless, this method might change based on the analysis's goal and circumstances. Certain lenders could modify the terms of the funding request and their risk appetite when it comes to NOI or TDS. 

For instance, some lenders might add back certain income categories like interest income or dividends received, or they might eliminate non-cash costs like amortization and depreciation from NOI. Additionally, some lenders might omit some debt categories like subordinated debt or revolving credit lines from TDS or include other fixed charges like lease payments or preferred dividends.

Taking into consideration the tax implications of interest payments—interest expenses are tax deductible, while principal repayments are not—will result in a more accurate calculation of TDS. The formula for TDS with tax adjustment is:

TDS = (Interest x (1 - Tax Rate)) + Principal

where:

• Interest is the total amount of interest due in a given period, calculated on both current and non-current portions of debt.
• Tax Rate is the effective income tax rate of the company.
• Principal is the total amount of principal due in a given period, usually equal to the current portion of long-term debt.

How to Calculate Debt Service Coverage Ratio (DSCR)?

The net operating income (NOI) must be divided by the total debt service (TDS) in order to get the DSCR. Net Operating Income (NOI) is the amount of money received from business operations after operating costs are subtracted, but before taxes and interest are paid. TDS is the total amount needed in a specific period of time to pay off the main and interest on the loan.

The formula for DSCR is:

DSCR = NOI / TDS

where:
NOI = Revenue - Operating Expenses
TDS = (Interest x (1 - Tax Rate)) + Principal

Examples of Debt Service Coverage Ratio (DSCR)

Let's look at some examples of how to calculate DSCR for different businesses.

Example 1

ABC Inc. is a manufacturing company that has a revenue of $10 million and operating expenses of $6 million. It has a long-term debt of $20 million with an interest rate of 10% and a tax rate of 25%. It pays $5 million in principal every year. What is its DSCR?

Solution:

NOI = Revenue - Operating Expenses
NOI = $10 million - $6 million
NOI = $4 million

TDS = (Interest x (1 - Tax Rate)) + Principal
TDS = ($20 million x 10% x (1 - 25%)) + $5 million
TDS = ($1.5 million) + $5 million
TDS = $6.5 million

DSCR = NOI / TDS
DSCR = $4 million / $6.5 million
DSCR = 0.62

ABC Inc. has a DSCR of 0.62, which means it does not generate enough income to cover its debt obligations.

Example 2

XYZ Ltd. is a service company that has a revenue of $8 million and operating expenses of $4 million. It has a long-term debt of $15 million with an interest rate of 8% and a tax rate of 30%. It pays $3 million in principal every year. What is its DSCR?

Solution:

NOI = Revenue - Operating Expenses
NOI = $8 million - $4 million
NOI = $4 million

TDS = (Interest x (1 - Tax Rate)) + Principal
TDS = ($15 million x 8% x (1 - 30%)) + $3 million
TDS = ($0.84 million) + $3 million
TDS = $3.84 million

DSCR = NOI / TDS
DSCR = $4 million / $3.84 million
DSCR = 1.04

XYZ Ltd. has a DSCR of 1.04, which means it barely generates enough income to cover its debt obligations.

Example 3

PQR Co. is a retail company that has a revenue of $12 million and operating expenses of $8 million. It has a long-term debt of $25 million with an interest rate of 12% and a tax rate of 20%. It pays $4 million in principal every year. What is its DSCR?

Solution:

NOI = Revenue - Operating Expenses
NOI = $12 million - $8 million
NOI = $4 million

TDS = (Interest x (1 - Tax Rate)) + Principal
TDS = ($25 million x 12% x (1 - 20%)) + $4 million
TDS = ($2.4 million) + $4 million
TDS = $6.4 million

DSCR = NOI / TDS
DSCR = $4 million / $6.4 million
DSCR = 0.63

PQR Co. has a DSCR of 0.63, which means it does not generate enough income to cover its debt obligations.

Limitations of Debt Service Coverage Ratio (DSCR)

DSCR is a useful metric to measure the ability of a business to service its debt, but it also has some limitations, such as:

• The unpredictability or uncertainty of future cash flows, which can be impacted by a variety of factors like competitiveness, consumer demand, market conditions, etc., is not taken into consideration by DSCR.
• The quality and sustainability of the revenue sources, which can be impacted by things like product difference, brand reputation, and customer loyalty, are not taken into account by DSCR.
• The opportunity cost and other potential uses of the cash flow, which may be allocated to more lucrative or strategically important projects or activities, are not taken into account by the DSCR.
• Depending on the accounting techniques or presumptions—such as depreciation, amortization, inventory valuation, etc.—used to determine NOI and TDS, DSCR may differ.
• Due to variations in capital structures, operating cycles, tax rates, and other factors, DSCR may not be transferable to other industries or businesses.

FAQ

A high DSCR indicates that a company has sufficient income to cover its current debt obligations, which can make it more attractive to investors and lenders. It suggests the company is less likely to default on its debt.

Yes, DSCR can be negative if the net operating income is negative, meaning the company’s operating expenses exceed its revenues. This implies the company is not generating enough income from its operations to service its debt, which is a red flag for lenders and investors.

Unlike other financial ratios that might focus on profitability, liquidity, or overall leverage, DSCR specifically measures a company’s ability to cover its debt obligations with its operating income. It provides insight into the company’s debt management and its capacity to service its current debts.

A company can improve its DSCR by increasing its net operating income or by reducing its total debt service. This could be achieved through increasing revenues, decreasing operating expenses, or managing debts more effectively.

Yes, while DSCR is commonly used to assess businesses, it can also be applied to personal finance. For an individual, it measures the ability to cover personal debt obligations, such as mortgage or car loan payments, with their net income.