Debt service coverage ratio
The debt service coverage ratio measures a company’s ability to make debt payments on time. It is one of three calculations used to measure debt capacity, along with the debt-to-equity ratio and the debt-to-total assets ratio.
Essentially, the debt service coverage ratio shows how much cash a company generates for every dollar of principal and interest owed. It is calculated by dividing a company’s EBITDA (earnings before interest, taxes, depreciation and amortization) by all outstanding debt payments of interest and principal.
Using ABC Co.’s income statement below, we can calculate its cash inflow (EBITDA) as follows:
Net profit + interest + taxes + depreciation + amortization
$20,000 + $8,000 + $10,000 + $5,000 = $43,000
From a banker’s perspective this means ABC Co. has $43,000 in cash flow available to service its debts.
More about the debt service coverage ratio
To calculate the ratio we need to look up the details of the company’s debt payments in the notes to the financial statements. Let’s assume it has principal payments of $5,000 in addition to the interest payments of $8,000 we see on the income statement. Using those figures, the company’s debt service coverage ratio would be:
43,000 (5,000 + 8,000) = 3.3 times
This means ABC Co. generates $3.30 for every $1 in principal and interest owed—a very healthy ratio. It suggests the company is capable of taking on more debt, if necessary.
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Leverage ratios provide an indication of your company’s long-term solvency and to what extent you are using long-term debt to support your business.