Debt service coverage ratio
The debt service coverage ratio (DSCR) is a key measure of a company’s ability to repay its loans, take on new financing and make dividend payments.
It is one of three metrics used to measure debt capacity, along with the debt-to-equity ratio and the debt-to-total assets ratio.
“Debt service coverage ratio is a basic indicator of your company’s financial health and one that all entrepreneurs should be familiar with,” says Alka Sood, Senior Business Advisor with BDC Advisory Services, who counsels businesses on financial management and strategic planning.
“It’s useful for evaluating your capacity to finance future growth and is widely used by bankers and investors to understand a company’s creditworthiness and prospects.”
Debt service coverage ratio is a basic indicator of your company’s financial health and one that all entrepreneurs should be familiar with.
How to calculate the debt service coverage ratio?
The debt service coverage ratio shows how much EBITDA (earnings before interest, taxes, depreciation and amortization) a company generates for every dollar of interest and principal paid.
The ratio (also known as the debt servicing ratio) is typically calculated with this formula:
Despite its simple formula, the debt service coverage ratio is often miscalculated. “For this indicator to be useful, you have to make sure you’re calculating it with the right inputs,” Sood says.
3 common mistakes when calculating the debt service coverage ratio
1. Principal repayment amount
One of the most common reasons for errors is the calculation of the principal amount. Principal payments are not recorded on income statements and only the balances outstanding on loans are shown on balance sheets. “Some extra internal record-keeping is needed to calculate the principal payments that are made in an accounting period,” Sood says.
The amounts can get especially confused if a company has obtained new financing during the year. In that case, debt payments for various loans may be lumped together, which can make it difficult to determine the amount of principal repaid.
To arrive at the correct calculation, Sood recommends asking your financial institution for a separate repayment schedule for each of your company’s loans and using these statements to estimate the amounts.
She also suggests having your bookkeeper or accountant double-check those figures. “Since many businesses miscalculate the amount, the bookkeeper or accountant often has to go back and adjust it.”
2. Capital lease expenses
A second source of confusion is over whether to include capital lease expenses in the calculation. A capital lease is a long-term lease of an asset; for accounting purposes, it’s seen as a purchase of the asset. For example, a business may sign a lease to rent a forklift for three years, where the useful life of the equipment is five years, with the company able to purchase it at fair value at the end of the lease. There are special accounting rules for recording these types of leases because the lessor has essentially derived the economic value of the asset as if the asset were purchased.
Some lenders exclude capital lease expenses from the debt service coverage ratio, while other analysts include these costs. If capital lease expenses are included, the resulting metric is referred to as the fixed-charge coverage ratio.
3. EBITDA vs EBIT
There can also be confusion over whether to use EBITDA or EBIT (earnings before interest and taxes) to calculate the debt service coverage ratio. Either one can be used, though Sood prefers EBITDA because it is a quick approximation of cash flow.
An additional source of potential confusion is the fact that EBITDA doesn’t typically appear on a company’s income statement. (This is because EBITDA isn’t a metric recognized in the Generally Accepted Accounting Principles, or GAAP, standard.) You need to calculate EBITDA using the income statement’s figures. Here is the formula:
Check with you accountant
To be sure you’re using the right elements to calculate your debt service coverage ratio, check with your banking or investment partners to find out which formula they need to see.
You can also calculate the debt service coverage ratio in your financial projections, using forecasted figures.
A lot of entrepreneurs look at this and think, ‘Oh, that’s just bookkeeping.’ It’s not just bookkeeping. It’s about ensuring the future financial health of your company.
What is the debt service coverage ratio used for?
The debt service coverage ratio is generally used for three main purposes:
Lenders use the ratio as a key measure of a company’s ability to meet its interest and principal payment obligations.
Shareholders, potential investors and buyers of a business use the ratio as a gauge of the company’s financial health and dividend potential. “It shows how much money is left over for shareholders or investors,” Sood says.
3. Strategic planning
Entrepreneurs can use the ratio to evaluate their capacity to grow and obtain additional financing. “If all of my money is going to pay back debt, I won’t have anything left to reinvest in the company,” Sood says. “I’m going to have to find an alternative way to finance my growth projects.”
It's a good idea to calculate the ratio when you do financial forecasts for a major investment or as part of strategic planning. “That’s one of the key values of this indicator,” Sood says. “It helps you see if you’re still going to be in the right state of health. If you’re not, then you better go back and figure out how you’re going to make it work so you don’t violate any of these risk ratios.
“A lot of entrepreneurs look at this and think, ‘Oh, that’s just bookkeeping.’ It’s not just bookkeeping. It’s about ensuring the future financial health of your company.”
Debt service coverage ratio example
Using ABC Co.’s income statement below, we can see that the company had EBITDA of $282,800 and made interest payments of $21,000 during the year. If principal repayments (which don’t typically appear on an income statement) were $49,700, then the total debt service would be $70,700 and the debt service coverage ratio would be 4.
What is a good or bad debt service coverage ratio?
A ratio of 2 or higher is generally seen to be healthy. “If you’re at 1, all of the EBITDA you earn is going straight to debt,” Sood says. “There’s nothing left for taxes, much less for reinvesting in your business or paying dividends.”
That said, Sood cautions that lenders and other partners often have different levels that they believe are healthy or risky. “There’s no hard-and-fast number,” she says.
These stakeholders also know a company’s ratio may be temporarily affected by unique conditions. For example, it may have made a large investment during a time when expected sales growth had yet to fully show up as higher earnings.
“The number is informational,” Sood says. “It invites further discussion.”
How do banks use the debt service coverage ratio?
When evaluating a loan request, lenders typically look at a company’s debt service coverage ratio alongside several other measures of a company’s financial health and debt capacity.
“We look at it in the context of a number of indicators, and then we make our assessment,” Sood says. “This ratio might be way out of whack, but the client may be doing exceptionally well in some other area. It’s part of understanding the company’s overall context.”
A bank may also require a loan recipient to report ratio numbers at different periods of a loan’s duration to assess whether the company is maintaining financial health.
The debt service coverage ratio is often evaluated alongside these other metrics:
- Fixed-charge coverage ratio (see below)
- Interest coverage ratio (see below)
- Debt-to-equity ratio
How does the debt service coverage ratio relate to real estate?
1. Real estate purchases
Buying real estate could affect your debt service coverage ratio by affecting your company’s debt payments and if the real estate earns additional income for your company.
If your company has a poor debt service coverage ratio, this could affect its ability to obtain real estate financing.
Fixed-charge coverage ratio vs. debt service coverage ratio
The fixed-charge coverage ratio is a variant of the debt service coverage ratio in which capital lease expenses are included in the debt repayments.
How do you analyze your debt service coverage ratio?
Sood advises companies to review their debt service coverage ratio annually as a way of checking their financial health and compare it to prior years. As mentioned above, if the ratio is below 2, it may warrant a closer look.
“If you see it’s going up, then you can be reassured,” she says. “If you see it’s deteriorated, then it’s an opportunity to dig down to find out what happened and make a plan to turn that ratio around.”
Interest coverage ratio vs. debt service coverage ratio
Interest coverage ratio (sometimes called the times interest earned ratio) is another frequently used metric of a company’s financial health. It’s very similar to the debt service coverage ratio, the only difference being that the interest coverage ratio includes only interest in the debt calculation. Principal is excluded.
The interest coverage ratio is calculated with this formula:
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**This is interest and principal repayments on short- and long-term debt due in the period (typically one year).