The Debt Service Coverage Ratio, also known as the DSCR, measure that tracks a business capacity to pay for all its financial commitments that are due within the next 12 months. This metric employs the company’s latest annual cash flow figure to estimate the number of times such amount covers for any upcoming debt obligation, including principal, interest, financial fees, penalties and any other item that may be related to those debts.
What is the Debt Service Coverage Ratio?
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The Debt Service Coverage Ratio (DSCR) is employed by lenders, investors and analysts to estimate the payment capacity of borrowers and businesses in order to determine if they are in a good position to fulfill their soon-to-be-due financial obligations.
The metric incorporates the business latest annual cash flow figure and divides it by the total amount due in order to calculate how many times this figure covers for the entire burden. A business that has a low Debt Service Coverage Ratio carries a high risk of defaulting either partially or totally on its debt services for the next 12 months.
For bondholders and lenders, this metric is particularly important as it indicates if the business will be in a position to cover for their coupon payments, principal repayments or loan installments.
Debt Service Coverage Ratio Formula
The Debt Service Coverage Ratio formula calculation has several possible variations and while the purpose of it remains the same, different financial institutions, investors and analysts may incorporate or not some elements to it. Therefore, the end result may be different even though it is the same subject.
The formula that appears to be more accurate is the following:
DSCR = EBITDA / Total Debt Service
DSCR Ratio Equation Components
EBITDA: Earnings before Interest, Tax, Depreciation & Amortization
Total Debt Service: The sum of all pending principal and interest payments, along with any financial fees, sinking fund payments and any other item related to debt.
Some of the variations for the formula include substituting the EBITDA metric for EBIT, or even for net income plus some adjustments. Also, the interest payments added to the Total Debt Service may be deducted considering the tax deduction of such payments.
In any case, while these changes to the formula may have an effect in the exact ratio, the degree in which the end result may be affected is usually not that high.
DSCR Example
DecoHome is a firm comprised by interior designers, architects and civil engineers who offer design and remodeling services to homeowners who are looking to invest some money into their properties.
The company has been very successful in the high-end area of Los Angeles and they are looking to expand the business to other cities through a network of branches. In order to do so, they need to issue a bond for $2,600,000 to finance this expansion. This bond will be sold over the counter to private investors who are interested in the interest rate offered by the company.
The company already has some debt commitments due in the next 12 months, and some investors are worried about how capable the firm is to fulfill those obligations. Nevertheless, the firm’s Chief Financial Officer assured them that the business is in a healthy position to do so. In order to back that statement with numbers, he decided to estimate the company’s Debt Service Coverage Ratio for the next 12 months, considering that the following amounts are due:
Principal payments: $2,500,000
Interest payments: $78,000
Sinking Fund Payments: $560,000
Other Financial Expenses: $24,000
Total Debt Service for the next 12 months: $3,162,000
Additionally, the business’ trailing 12 month EBITDA is $10,450,000. Therefore, the current Debt Service Coverage Ratio for DecoHome is:
DSCR = $10,450,000 / $3,162,000 = 3.30
This means that DecoHome has produced 3.30 times the cash flow required to fulfill these commitments, which is a healthy ratio for they industry they are in.
Debt Service Coverage Ratio Analysis
One of the keys to analyze the Debt Service Coverage Ratio through financial statements is to be able to properly locate the principal payments that are due soon. This information is often located in the notes, commonly in the form of an amortization schedule.
Some companies decide to constitute a sinking fund to alleviate the impact in the company’s cash flow coming from large principal payments. This fund itself is not a part of the debt service. Instead, the payments scheduled to be made within the next 12 months are included in the debt service calculation. If the company already has a sinking fund to cover for due principal payments, the outstanding balance of such fund should be deducted from the total debt service calculation in order to estimate how much they will actually have to disburse.
On the other hand, a healthy Debt Service Coverage Ratio may look different for different industries. From a lender’s standpoint, if the industry is known for its volatility, they will often demand a higher Debt Service Coverage Ratio. Contrary to that, if the industry or even the business has a solid past record of earnings and sales, the lenders may soften the Debt Service Coverage Ratio requirement.
In any case, a ratio lower than 1 means that the cash flow generated by the company in the last 12 months is not enough to cover for its upcoming financial commitments. In turn, a ratio higher than one, means the company has generated enough cash flow to cover for its commitments. Yet, a ratio of more than 3 is commonly considered healthy enough.
Debt Service Coverage Ratio Uses, Cautions, & Pitfalls
While a ratio lower than 1 definitely means that the company is in a financially risky situation, it doesn’t necessarily mean it will default on its payments for the next 12 months. If the company has the possibility to refinance their upcoming principal payments, postponing them until a further date, then the company’s Debt Service Coverage Ratio may be higher than estimated.
Yet, if the company is unable to recover from such risky position in a short period of time, it is possible that lenders and bondholders will eventually decline to refinance the principal, which will force the company to pay for the debt. That doesn’t necessarily mean the company will go bankrupt, but it definitely puts the business in a sensitive position and its cash reserves will probably suffer if such scenario occurs.