What is the Debt-Service Coverage Ratio (DSCR)?
The DSCR helps to show if a company can pay back its yearly loans and interest with the money it earns from its regular business activities. This ratio is very useful for figuring out how well a company can manage its long-term debt.
The DSCR looks at all the current loans a person or company is repaying, as well as any new loans they want to take. To understand DSCR, you need to know a company's yearly net operating income and its total debt payments.
If you want to understand how businesses can manage their debt efficiently, consider exploring the working capital cycle.
What is the debt service coverage ratio used for?
The DSCR is used primarily by lenders to assess the financial viability of companies seeking loans. It indicates whether a company can cover its debt obligations using its operating income. A high DSCR suggests that the company generates enough income to meet its debt payments, making it a lower risk for lenders. This ratio is particularly significant in the evaluation of long-term loans and business loans, ensuring that the company's cash flow is sufficient for loan repayment. Capital structure plays an important role in determining how much debt a company takes on, impacting the DSCR. Financial analysts and business owners also use DSCR to measure a company's financial health and make informed decisions about future investments. Additionally, it helps companies ensure they are not over-leveraged and can maintain healthy operations while managing debt.
Components of the Debt-Service Coverage Ratio
The DSCR is made up of 2 main parts: net operating income and total debt service. To figure out the DSCR, you simply divide the net operating income by the total debt service. Let us break these down:
- Net operating income: This is the money a company makes from its regular business activities after taking away operating costs but before interest and taxes are deducted. It is usually the same as Earnings Before Interest and Tax (EBIT)
- Total debt service: This includes all the debt payments a company needs to make in a year, such as loan repayments, interest, lease payments, and sinking fund contributions. On the balance sheet, this will show up as short-term loans and the remaining balances of long-term loans. A company’s business environment can influence how debt is structured and managed.
Debt service coverage ratio formula
- Formula: The debt-service coverage ratio (DSCR) is calculated by dividing a company’s net operating income by its total debt service.
DSCR = Net Operating Income/Total Debt Service
- Net operating income: This includes the company’s earnings before interest, taxes, depreciation, and amortisation (EBITDA), providing a clear picture of the business’s income before non-cash deductions.
- Total debt service: This represents the sum of all debt obligations, including interest and principal payments.
- Importance of depreciation: While calculating net operating income, depreciation is excluded since it is a non-cash expense, allowing a clearer view of actual cash flow.
- Formula breakdown: DSCR = Net Operating Income/Total Debt Service, where:
Net Operating Income = Revenue-COECOE
COE = Certain operating expenses
Total Debt Service = Current debt obligations
How to calculate the Debt-Service Coverage Ratio (DSCR)?
To calculate the DSCR, follow these steps:
- Determine the net operating income: Gather the company’s net operating income, which is the income remaining after all operating expenses are deducted from total revenues.
- Identify the total debt service: Total the company’s debt obligations, which includes both principal and interest payments for the period.
- Apply the formula: Divide the net operating income by the total debt service. The resulting number is the DSCR.
- Interpret the ratio: A ratio greater than 1 means the company generates sufficient income to cover its debt payments, while a ratio below 1 suggests that the company may struggle to meet its debt obligations.The cost of capital also impacts how companies evaluate their debt service coverage ratio and funding strategies.
An example for calculating DSCR
Here are the two distinct examples of DSCR for two different sectors:
1. Real estate
A real estate company generates ₹10 lakhs in rental income annually and has ₹6 lakhs in debt service. The DSCR will be calculated as ₹10 lakhs / ₹6 lakhs = 1.67, indicating the company can cover its debt 1.67 times with its rental income.
2. Income one below one
A manufacturing company earns ₹15 lakhs in net operating income and has a debt service of ₹12 lakhs. The DSCR will be ₹15 lakhs / ₹12 lakhs = 1.25, showing that the company has sufficient income to cover its debt.
What is a good or bad debt service coverage ratio?
A good DSCR is generally considered to be above 1.25, meaning the company generates sufficient profit to cover its debt obligations with a cushion. This ensures that even if there is a drop in income, the company can still meet its debt payments.
A bad DSCR is below 1, indicating that the company is not generating enough income to cover its debt, putting it at risk of default. Lenders view a high DSCR as a sign of financial stability, while a low DSCR raises red flags about the company’s ability to manage its debts and generate profit. Entrepreneurs working on their entrepreneurship journey must consider DSCR for managing their long-term financial health.
Interest coverage ratio vs. DSCR
The Interest Coverage Ratio (ICR) measures a company’s ability to pay interest on its debt using its revenue, while DSCR includes both interest and principal in the calculation. DSCR provides a more comprehensive view of a company’s ability to cover total debt obligations. ICR only focuses on interest payments, offering insight into short-term debt management. Both ratios are essential for assessing a company’s financial health, but DSCR is more relevant for long-term debt evaluation, while ICR is useful for managing immediate revenue and expenses.
Advantages and disadvantages of DSCR
| Advantages | Disadvantages |
| Helps assess a company’s debt repayment ability | Can be misleading if income is inconsistent |
| Crucial for securing business loans | Ignores future changes in expenses or revenue |
| Highlights a company’s financial health | May not reflect short-term liquidity issues |
| Useful for long-term financial planning | Calculation may vary across industries |
How to calculate the DSCR in Excel?
- Open Excel: Set up a spreadsheet with two columns: one for income and one for debt service.
- Input values: Enter the company’s net operating income and total debt service for a specific period.
- Apply the formula: In an empty cell, type = NetOperatingIncome/TotalDebtService and press Enter. The result will be the DSCR.
- Check your data: Ensure that depreciation is not included in the net operating income calculation, as it is a non-cash expense.
- Analyse the ratio: Interpret the result to assess if the company can meet its debt obligations.
Factors Influencing DSCR
Several factors affect a company's debt service coverage ratio, including the net operating income (NOI) and total debt service (TDS). Factors influencing the NOI include the company’s operating income, interest rates, debt structure, non-operating income and expenses, and business cycles. Other factors affecting the TDS include operating costs, revenue fluctuations, loan terms, depreciation, amortisation, salaries, capital expenditures, and more.
By understanding the key factors that impact DSCR, companies can improve their financial position and make better borrowing decisions. Lenders may also use this ratio to guide their lending decisions. Knowing these factors gives both borrowers and lenders a clearer view of a company's ability to cover its debt. This allows them to evaluate the company’s overall financial health and long-term viability.
The Debt-Service Coverage Ratio (DSCR) is a crucial financial metric that measures a company’s ability to repay its debt. It’s a key indicator used by lenders when assessing eligibility for Bajaj Finserv Business Loan. A higher DSCR represents strong financial health, while a low DSCR can indicate potential risk. Calculating DSCR in Excel simplifies the process, enabling businesses to make informed decisions regarding debt management.
