A business is insolvent when it has both a negative debt service coverage ratio—meaning it can’t make its debt payments as they come due—and it has no liquidity—that is, it has no means of converting its assets to cash.
Banks mainly use the debt service coverage ratio to decide if a company will be able to meet its financial obligations. This is calculated by subtracting the principal and interest payments on all outstanding debts from the company’s earnings before interest, taxes, depreciation and amortization (EBITDA).
If this calculation returns a result of between 1.5 and 2.5, the company’s debt service coverage ratio is considered “safe”. Technically, a business can have a debt service coverage ratio of 1.0 and still be solvent, but it is operating under stress.
More about insolvency
If ABC Co. has an EBITDA of $43,000 for the three months ending at March 31, 2012 and its total debt payments for the period are $13,000, its debt service surplus would be:
$43,000 – $13,000 = $30,000
Its debt service coverage ratio would be ($43,000 / $13,000) = 3.3, which means that ABC Co. is servicing its current debt load with a large margin to spare.
When doing these calculations, the same time period is used to calculate the EBITDA and the debt payment requirements.
The notes to the financial statements include additional detail about the company’s debts, such as the nature of the various debts owed (whether short-term or long-term), interest rates and borrowing terms. This information is required to make the calculations.