Debt service coverage ratio is calculated to measure availability of profits with the company to pay back its current debt obligations. In short its referred to as DSCR. The ratio reflects the company’s ability to service debt obligations for a given period of time. DSCR or debt service coverage ratio can also be used to analyze availability of cash inflow to repay current interest plus principal payment obligations of a firm, project, government finance and individual borrowers.
For instance, if you want to finance a project, as a lender, the first thing you need to calculate is the DSCR. It will let you know the ability of the project to borrow and pay off the interest plus principal amount of a loan.
Formula to calculate Debt service coverage ratio
To calculate DSCR of a company, partnership firm or any other organisation following two things are required;
- Cash flow of the company
- Total Debt service of the company
For a company, cash flow is calculated by taking net operating income before deducting interest and taxes from the income statement. It’s also referred to as EBIT. Here is the formula to calculate earnings before interest and tax;
EBIT = total revenue – total operating expenses
If you have company’s net profit after interest and tax, then you can add back interest, depreciation, amortization and taxes paid by the company to arrive at EBIT.
Total debt service = total current year loan obligations = principal + interest
Out of total debt service, interest is tax deductible. Therefore to calculate debt service coverage ratio, companies always prefer to take the tax impact on interest into the formula. Therefore, total debt service = interest (1-tax rate)+principal
DSCR = EBIT / total debt service = EBIT / [interest(1-tax rate)+principal]
Example
Net operating income before interest and tax = Rs 30,00,000
Total interest plus principal = Rs 3,00,000
DSCR = Rs 30,00,000 / Rs 3,00,000 = 10
In this case, DSCR is 10. This means the company’s EBIT is 10 times the total amount of debt obligations. It basically tries to answer the following question:
- can the project pay back the loan amount on time and full.
- Whether or not the business can take on the additional loan.
- What is the limit up to which loan can be allowed to a project.
- Do you need any additional security to cover the project risk.
Interpretation of debt service coverage ratio
If companies DSCR is less than 1, then it has a negative cash flow due to which the company in current scenario will unable to pay its interest and principal amount of the loan.
If DSCR is close to 1, then company can default in any economic downturn. In case it’s more than 1, then the company has sufficient cash to pay interest and principal amount of the loan. This means DSCR over 1 is good, the higher the better.
In the case of industry slow down, business will have less sales, if expenses are not managed according to the slow down, then the company might fall behind on loan payments. Regular monitoring of the business and industry might help to assess the company’s financial position better.
Therefore, as a lender or analyst, you should not only look at the ratio to make a decision. You have to get into its components and how the business will react in case of any economic downturn or industry related issues.
Why to calculate DSCR
There can be a number of reasons to calculate DSCR. Here are the 3 most important cases where DSCR is calculated;
- Banks, financial institutions and other lenders assess borrower’s DSCR before allowing loan.
- Creditors use it to evaluate whether to provide additional financing to the company or not.
- To compare similar set of companies to know their financial conditions.
You can improve your debt service coverage ratio by increasing business revenue, with lower business expenses and by obtaining equity finance in order to lower debt obligations.
Do not get confused between interest coverage ratio and DSCR. Interest coverage ratio is calculated by dividing EBIT by total interest due for a particular period. In this case you don’t take the principal amount into calculation.
If you are applying for an additional loan, then while providing project report you need to calculate DSCR. In this case, DSCR should be calculated by taking existing and additional debt obligations in comparison to the projected EBIT.
