What Is the Debt-Service Coverage Ratio (DSCR)?
The debt-service coverage ratio (DSCR) measures a firm's available cash flow to pay current debt obligations. The DSCR shows investors and lenders whether a company has enough income to pay its debts. The ratio is calculated by dividing net operating income by debt service, including principal and interest.
Key Takeaways
- The debt-service coverage ratio (DSCR) is a measure of the cash flow available to pay current debt obligations.
- DSCR measures a business’s cash flow versus its debt obligations.
- Lenders use DSCR to determine whether a business has enough net operating income to pay back loans.
- DSCR equals net operating income divided by debt service, including principal and interest.
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Understanding Debt-Service Coverage Ratio (DSCR)
The debt-service coverage ratio is a widely used indicator of a company's financial health, especially those who are highly leveraged with debt. Debt service refers to the cash needed to pay the required principal and interest of a loan during a given period.
The ratio compares a company's total debt obligations to its operating income. Lenders, stakeholders, and partners target DSCR metrics, and DSCR terms and minimums are often included in loan agreements.
Calculating DSCR
The formula for the debt-service coverage ratio requires net operating income and the total debt servicing for a company. Net operating income is a company's revenue minus certain operating expenses (COE), not including taxes and interest payments. It is often considered equal to earnings before interest and tax (EBIT).
DSCR=TotalDebtServiceNetOperatingIncomewhere:NetOperatingIncome=Revenue−COECOE=CertainoperatingexpensesTotalDebtService=Currentdebtobligations
Total debt service refers to current debt obligations, meaning any interest, principal, sinking fund, and lease payments due in the coming year. On a balance sheet, this will include short-term debt and the current portion of long-term debt.
Income taxes complicate DSCR calculations because interest payments are tax-deductible, while principal repayments are not. A more accurate way to calculate total debt service is, therefore, to compute the following:
TDS=(Interest×(1−TaxRate))+Principalwhere:TDS=Totaldebtservice
Lender Considerations
The debt-service coverage ratio reflects the ability to service debt given income level. DSCR shows how healthy a company's cash flow is and can determine how likely a business is to qualify for a loan.
Lenders routinely assess a borrower's DSCR. A DSCR of 1 indicates a company has exactly enough operating income to pay off its debt service costs. A DSCR of less than 1 denotes a negative cash flow, and the borrower may be unable to cover or pay current debt obligations without drawing on outside sources or borrowing more. A DSCR of 0.95 means there is only sufficient net operating income to cover 95% of annual debt payments.
If the debt-service coverage ratio is too close to 1, the entity may appear vulnerable, and a minor decline in cash flow could render it unable to service its debt.Lenders may require the borrower to maintain a minimumDSCRwhile the loan is outstanding.
2.0 or Greater
Though there is no industry standard, a DSCR of at least 2 is considered very strong and shows that a company can cover two times its debt. Many lenders will set minimum DSCR requirements between 1.2 and 1.25.
Interest Coverage Ratio vs. DSCR
Theinterest coverage ratio indicates the number of times that a company's operating profit will cover the interest it must pay on all debts for a given period. This is expressed as a ratio and is most often computed annually. Divide the EBIT for the established period by the total interest payments due for that same period. The EBIT, often called net operating income or operating profit, is calculated by subtracting overhead and operating expenses, such as rent, cost of goods, freight, wages, and utilities, from revenue.
The higher the ratio of EBIT to interest payments, the more financially stable the company. This metric only considers interest payments and not payments made on principal debt balances that may be required by lenders.
The debt-service coverage ratio assesses a company's ability to meet its minimum principal and interest payments, includingsinking fund payments. To calculateDSCR, EBIT is divided by the total amount of principal and interest payments required for a given period to obtain net operating income. Because it takes into account principal payments in addition to interest, the DSCR is a more robust indicator of a company's financial fitness.
Advantages and Disadvantages of DSCR
Advantages of DSCR
DSCR, like other ratios, have value when calculated consistently over time. A company can calculate monthly DSCR to analyze its average trend over some time and project future ratios. For example, a declining DSCR may be an early signal for a decline in a company's financial health. Alternatively, it can be used extensively in budgeting or strategic planning.
DSCR may also have comparability across different companies. Management may use DSCR calculations from its competitors to analyze how it is performing relative to others, including analyzing how efficient other companies may be in using loans to drive company growth.
DSCR is also a more comprehensive analytical technique when assessing the long-term financial health of a company. Compared to the interest coverage ratio, DSCR is a more conservative, broad calculation. DSCR is also an annualized ratio that often represents a moving 12-month period. Other financial ratios are usually a single snapshot of a company's health; therefore, DSCR may be a more true representation of a company's operations.
Disadvantages of DSCR
The DSCR calculation may be adjusted to be based on net operating income, EBIT, or EBITDA (depending on the lender's requirement). If operating income, EBIT, or EBITDA are used, the company's income is potentially overstated because not all expenses are being considered. For example, in all three examples, income is not inclusive of taxes.
Another limitation of DSCR is its reliance on accounting guidance. Though debt and loans are rooted in obligatory cash payments, DSCR is partially calculated on accrual-based accounting guidance. Therefore, there is a little bit of inconsistency when reviewing both a set of GAAP-based financial statements and a loan agreement that stipulates fixed cash payments.
DSCR
Advantages
Can be calculated over a period of time to better understand a company's financial trend
May be used to compare operational efficiency across companies
Includes more financial categories (i.e., principal repayments) than other financial ratios
May be a more comprehensive analysis of a company's financial health as it is often calculated on a rolling annual basis
Disadvantages
May not fully incorporate a company's finances as some expenses (i.e., taxes) may be excluded
Has heavy reliance on accounting guidance which may widely vary from actual timing of cash needs
May be consider a more complex formula compared to other financial ratios
Does not have consistent treatment or requirement from one lender to another
Example of DSCR
Let's say a real estate developer is seeking a mortgage loan from a local bank. The lender will want to calculate the DSCR to determine the ability of the developer to borrow and pay off their loan as the rental properties they build generate income.
The developer indicates that net operating income will be $2,150,000 per year, and the lender notes that debt service will be $350,000 per year. The DSCR is calculated as 6.14x, or the borrower can cover their debt service more than six times, given their operating income.
DSCR=$350,000$2,150,000=6.14
Example of Lender Terms
In the image below, MK Lending Corp has outlined its debt requirements for new mortgages. The columns highlighted yellow represent investors with a DSCR greater or equal to 1.0, while the orange columns represent investors with a DSCR less than 1.0. Because the yellow investors are less risky, their loan terms and LTV/CLTV terms are more favorable than the orange investors.
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Example of Loan Agreement
In the example below, Sun Country, Inc. entered into an agreement with the U.S. Department of Treasury and the Bank of New York Mellon. As part of the loan and guarantee agreement, Sun Country agreed to several financial covenants.
In the examples below, certain trigger events will occur should Sun Country's DSCR fall below a specified level. When triggers occur, certain stopgaps will be enacted to protect the lenders. For example, the lenders will receive 50% of select revenues for a specific amount of time should Sun Country's DSCR drop below 1.00.
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How Do You Calculate the Debt Service Coverage Ratio (DSCR)?
The DSCR is calculated by taking net operating income and dividing it by total debt service (which includes the principal and interest payments on a loan). For example, if a business has a net operating income of $100,000 and a total debt service of $60,000, its DSCR would be approximately 1.67.
Why Is the DSCR Important?
DSCR is a commonly used metric when negotiating loan contracts between companies and banks. For instance, a business applying for a line of credit might be obligated to ensure that their DSCR does not dip below 1.25. If it does, the borrower could be found to have defaulted on the loan. In addition to helping banks manage their risks, DSCRs can also help analysts and investors when analyzing a company’s financial strength.
What Is a Good DSCR?
A “good” DSCR depends on the company’s industry, competitors, and growth. A smaller company just beginning to generate cash flow might face lower DSCR expectations compared to a mature company already well-established. As a general rule, however, a DSCR above 1.25 is often considered “strong,” whereas ratios below 1.00 could indicate that the company is facing financial difficulties.
The Bottom Line
DSCR is a commonly used financial ratio that compares a company's operating income to the company's debt payments. The ratio can be used to assess whether a company has the income to meet its principal and interest obligations. The DSCR is commonly used by lenders or external parties to mitigate risk in loan terms.
Correction—May 17, 2023: This article has been amended to state that a DSCR of 1.0 indicates a business has exactly enough net operating income to cover its debt obligations, but lenders may require a DSCR greater than 1.0 to obtain funding.
