Debt Service Coverage Ratio

The debt coverage ratio is used to determine whether or not a company can turn enough of a profit to cover all of its debt. This is also often referred to as the debt service coverage ratio (DSCR). Typically banks and lenders use this formula to decide whether or not to award a company a business loan. 

If the company has any loans or credit lines on their account, this ratio would certainly be applicable. Additionally, this ratio can also be used by the individual company as an evaluation of their ability to cover their debts. For example, let’s say that a company wants to take on more debt to feed growth. But they want to figure out if they can safely take on that debt without serious risk to the health of the company. This would be a great use of the debt coverage ratio.  

Debt Coverage Ratio Formula

$$Debt\: Coverage\: Ratio = \dfrac{Net\: Operating\: Income}{Annual\: Debt\: Payments}$$

In this formula, the net operating income is your income after expenses. You do not have to include taxes, depreciation, amortization, or interest payments, but you can include them. If you did not want to include them, your formula would look like this:

$$Debt\: Coverage\: Ratio = \dfrac{Net\: Operating\: Income - T}{Annual\: Debt\: Payments}$$

  • T = taxes, depreciation, amortization, and interest payments

The annual debt payments includes any debt payments you are required to make on any of your debt during the course of the year. The debt payment amount should include both short-term debt and long-term debt. Essentially, any debt that your business has taken on should be considered. If you are applying for a loan, you would even include the potential new loan payments in this amount. 

Ideally, a company should have a debt coverage ratio that is higher than 1. Anything below 1 means that they are not bringing in enough profit to cover their debt obligations for that year. A ratio of greater than 1 suggests that they can cover the amount with a remaining profit. Usually, a company should have a debt ratio of 2 or more before they consider taking on additional debt. Financial lenders often prefer to see the ratio in this range. This would mean that they have their current debt well under control. 

For instance, if a company’s ratio is 0.75, then they would not want to take on any more debt because they cannot afford to pay for the debt they already have. But if a company has a score of 3, they would certainly be able to take on the added payments. However, it’s important to remember that just because you can afford to take on more debt doesn’t always mean that you should. There should be many other factors involved in this decision. 

Debt Coverage Ratio Example

A growing company is applying for a business loan. The banker reviewing their file wants to know if the income from their business can cover the cost of the new loan. Currently, they have an annual net income of $75,000. Their annual debt payments (including the potential payments from the new loan) total to $40,000. 

Let’s break it down to identify the meaning and value of the different variables in this problem. 

We can apply the values to our variables and calculate debt coverage ratio. 

  • Net Operating Income: 75,000
  • Annual Debt Payments: 40,000 

$$Debt\: Coverage\: Ratio = \dfrac{75{,}000}{40{,}000} = 1.88$$

In this case, they would have a debt coverage ratio of 1.88. 

Because of these formulas, the banker knows that they would have the annual profit to cover the cost of the new loan. However, since their debt coverage ratio is below a 2, they may consider not giving the company a new loan. Whatever the banker decides to do, this information is helpful in getting a sense of how much debt this company can handle based on its profits.  

Debt Coverage Ratio Analysis 

The debt coverage ratio is extremely helpful for gauging whether or not a company can handle its debt. Before loaning money, every lender wants some type of assurance that the money can be repaid. 

For individuals applying for loans or credit, lenders will look at their credit score. For a business, the lender would look at the debt coverage ratio. This will tell them that the company can either afford to take on more debt or it can’t. 

Calculating for this number can also help a financial lender estimate how much debt a company could take on and what type of repayment agreement to give them. 

The debt service coverage ratio is used regularly in leveraged company buyouts and in the real estate market as well. Some lenders can use the formula to calculate whether or not a property can take on a loan amount. 

Have you been considering taking on additional debt, but you’re wondering if you can handle it? You could try out the debt coverage ratio on yourself by using your projected annual net income for the year and compare it against your total debt payments annually. This could be specifically useful if you’re considering purchasing a home, and you want to make sure you can cover the payments in your budget. 

Debt Coverage Ratio Conclusion

  • The debt coverage ratio is a tool that is used to evaluate if a company’s profits can afford it’s current debt or to bring on new debt. 
  • The net profits in the debt coverage ratio can include taxes, depreciation, amortization, or interest payments but it does not have to. 
  • The formula for the debt coverage ratio includes two variables: the net operating income and the annual debt repayment amount. 
  • A ratio of less than one means that the company cannot afford to cover its debt payment obligations for that year. 
  • An optimum ratio should be equal or greater than 2. 

Debt Coverage Ratio Calculator

You can use the debt coverage ratio calculator below to check if a company’s profits can cover its debt payments by entering the required numbers.

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