Debt-Service Coverage Ratio (DSCR)

What Is the Debt-Service Coverage Ratio (DSCR)?

The debt-service coverage ratio applies to corporate, government, and personal finance. In the context of corporate finance, the debt-service coverage ratio (DSCR) is a measurement of a firm's available cash flow to pay current debt obligations. The DSCR shows investors whether a company has enough income to pay its debts.

Key Takeaways

  • The debt-service coverage ratio (DSCR) is a measure of the cash flow available to pay current debt obligations.
  • DSCR is used to analyze firms, projects, or individual borrowers.
  • The minimum DSCR that a lender demands depends on macroeconomic conditions. If the economy is growing, lenders may be more forgiving of lower ratios.
  • A DSCR calculation greater than 1.0 indicates there is barely enough operating income to cover annual debt obligations, while a calculation less than one indicates potential solvency problems.
  • While the interest coverage ratio calculates the ability to meet interest payments, DSCR incorporate principal obligations.
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The Debt-Service Coverage Ratio (DSCR)

Understanding Debt-Service Coverage Ratio (DSCR)

Debt-service coverage ratio is a widely used indicator of a company's financial health, especially those who are highly levered and carrying a lot of debt. The ratio compares a company's total debt obligations (including principal repayments and some capital lease agreements) to its operating income.

Different lenders, stakeholders, and partners will target different DSCR metrics. In addition, a company's history, industry, product pipeline, and prior relationships with lenders. External parties may also be more considerate during seasonal operation when a company's income is flexible, though DSCR terms are often included in loan agreements.

Formula and Calculation of DSCR

DSCR Formula and Calculation

The formula for the debt-service coverage ratio requires net operating income and the total debt servicing for the entity. Net operating income is a company's revenue minus certain operating expenses (COE), not including taxes and interest payments. It is often considered the equivalent of earnings before interest and tax (EBIT).

DSCR = Net Operating Income Total Debt Service where: Net Operating Income = Revenue COE COE = Certain operating expenses Total Debt Service = Current debt obligations \begin{aligned} &\text{DSCR} = \frac{ \text{Net Operating Income} }{ \text{Total Debt Service} } \\ &\textbf{where:} \\ &\text{Net Operating Income} = \text{Revenue} - \text{COE} \\ &\text{COE} = \text{Certain operating expenses} \\ &\text{Total Debt Service} = \text{Current debt obligations} \\ \end{aligned} DSCR=Total Debt ServiceNet Operating Incomewhere:Net Operating Income=RevenueCOECOE=Certain operating expensesTotal Debt Service=Current debt obligations

Some calculations include non-operating income in EBIT. As a lender or investor comparing different companies' creditworthiness—or a manager comparing different years or quarters—it is important to apply consistent criteria when calculating DSCR. As a borrower, it is important to realize that lenders may calculate DSCR in slightly different ways.

Total debt service refers to current debt obligations, meaning any interest, principal, sinking fund, and lease payments that are 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 Tax Rate ) ) + Principal where: TDS = Total debt service \begin{aligned} &\text{TDS} = ( \text{Interest} \times ( 1 - \text{Tax Rate} ) ) + \text{Principal} \\ &\textbf{where:} \\ &\text{TDS} = \text{Total debt service} \\ \end{aligned} TDS=(Interest×(1Tax Rate))+Principalwhere:TDS=Total debt service

Different lenders may slightly tweak how DSCR is calculated. For example, some may use operating income, EBITDA, or EBIT as the numerator.

Calculating DSCR Using Excel

To create a dynamic DSCR formula in Excel, you cannot simply run an equation that divides net operating income by debt service. Rather, you would title two successive cells, such as A2 and A3, "net operating income" and "debt service." Then, adjacent to those cells, in B2 and B3, you would place the respective figures from the income statement.

In a separate cell, enter a formula for DSCR that uses the B2 and B3 cells rather than actual numeric values (e.g., B2 / B3).

Even for a calculation this simple, it is best to use a dynamic formula that can be adjusted and recalculated automatically. One of the primary reasons to calculate DSCR is to compare it to other firms in the industry, and these comparisons are easier to run if you can simply plug in the numbers.

What DSCR Can Tell You

Whether the context is corporate finance, government finance, or personal finance, the debt-service coverage ratio reflects the ability to service debt given a particular level of income. The ratio states net operating income as a multiple of debt obligations due within one year, including interest, principal, sinking funds, and lease payments.

Lender Considerations

In the context of government finance, the DSCR is the amount of export earnings needed by a country to meet annual interest and principal payments on its external debt. In the context of personal finance, it is a ratio used by bank loan officers to determine income property loans.

The minimum DSCR a lender will demand can depend on macroeconomic conditions. If the economy is growing, credit is more readily available, and lenders may be more forgiving of lower ratios. A tendency to lend to less-qualified borrowers can, in turn, affect the economy's stability.

This was arguably the case leading up to the 2008 financial crisis. Subprime borrowers were able to obtain credit, particularly mortgages, with little scrutiny. When these borrowers began to default en masse, the financial institutions that had financed them collapsed.

Evaluating DSCR Outcomes

Lenders will routinely assess a borrower's DSCR before making a loan. A DSCR of less than 1 means negative cash flow, which means that the borrower will be unable to cover or pay current debt obligations without drawing on outside sources—in essence, borrowing more.

For example, a DSCR of 0.95 means that there is only sufficient net operating income to cover 95% of annual debt payments. In the context of personal finance, this would mean that the borrower would have to delve into their personal funds every month to keep the project afloat. In general, lenders frown on negative cash flow, but some allow it if the borrower has strong resources in addition to their income.

If the debt-service coverage ratio is too close to 1, for example, 1.1, the entity is vulnerable, and a minor decline in cash flow could render it unable to service its debt. Lenders may, in some cases, require that the borrower maintain a certain minimum DSCR while the loan is outstanding.

Some agreements will consider a borrower who falls below that minimum to be in default. Typically, a DSCR greater than 1 means the entity—whether an individual, company, or government—has sufficient income to pay its current debt obligations.

2.0 or Greater

Though there is no industry standard, a DSCR of at least 2 is considered very strong. Many lenders will set minimum DSCR requirements between 1.2 and 1.25.

Interest Coverage Ratio vs. DSCR

The interest 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 on an annual basis.

To calculate the interest coverage ratio, simply 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. This number reflects the amount of cash available after subtracting all expenses necessary to keep the business running.

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 is slightly more comprehensive. This metric assesses a company's ability to meet its minimum principal and interest payments, including sinking fund payments, for a given period. To calculate DSCR, 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 slightly more robust indicator of a company's financial fitness.

In either case, a company with a debt-service coverage ratio of less than 1.00 does not generate enough revenue to cover its minimum debt expenses. In terms of business management or investment, this represents a risky prospect since even a brief period of lower-than-average income could spell disaster.

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 a period of 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 the budgeting or strategic planning process.

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 technical when assessing the long-term financial health of a company. Compared to 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 requirement). If operating income, EBIT, or EBITDA are used, the company's income is potential 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 looking to obtain 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, which should mean the borrower can cover their debt service more than six times given their operating income.

DSCR = $ 2 , 150 , 000 $ 350 , 000 = 6.14 \begin{aligned} &\text{DSCR} = \frac{ \$2,150,000 }{ \$350,000 } = 6.14 \\ \end{aligned} DSCR=$350,000$2,150,000=6.14

Example of Lender Terms

In the imagine 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.

MK Lending Corp
MK Lending Corp, Select DSCR Terms.

MK Lending Corp

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.

Loan Agreement, DSCR Covenants
Loan Agreement, Example DSCR Covenants.

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 stage of growth. For instance, a smaller company that is just beginning to generate cash flow might face lower DSCR expectations compared to a mature company that is 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 will be able to use income to meet its principal and interest obligations. The DSCR is commonly used by lenders or external parties by implementing operational requirements to mitigate risk in loan terms.

Article Sources
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  1. U.S. Federal Reserve. "Federal Reserve History: Subprime Mortgage Crisis."

  2. The United States Department of the Treasury. "Loan and Guarantee Agreement."