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Debt Service Coverage Ratio (DSCR)

Debt Service Coverage Ratio (DSCR)
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Understanding key metrics is crucial for making informed decisions. One such metric that plays a vital role in evaluating the financial health and repayment capacity of an entity is the Debt Service Coverage Ratio (DSCR). Originating from the field of commercial real estate lending, the DSCR has expanded its significance across various industries and financial contexts. However, despite its importance, the concept of Debt Service Coverage Ratio remains elusive to a large portion of individuals. Therefore, today we’re going to explore this metric in detail. Shall we?

What is Debt Service Coverage Ratio(DSCR)?

The full form of DSCR is Debt Service Coverage Ratio. It is a fundamental metric used in corporate finance to assess a firm’s ability to meet its current debt obligations. Serves as a crucial indicator for both investors and lenders, offering valuable insights into whether a company generates sufficient income to cover its debts.

DSCR meaning flowchart

DSCR is one of the three metrics used to measure debt capacity, along with the debt-to-equity ratio and the debt-to-total assets ratio. 

By comparing a company’s net operating income with its total debt service, including principal and interest payments, the debt service coverage ratio quantifies the available cash flow that can be allocated. Investors can utilize tools like Microsoft Excel and financial statements to calculate the DSCR, taking into account various debt payments such as lease, interest, and principal amounts due within the upcoming year.

Here are some of the uses of DSCR:

  • Lenders use DSCR to assess the creditworthiness of borrowers and determine whether they are able to repay their loans.
  • Investors use DSCR to assess the financial health of companies and determine whether they are a good investment.
  •  Debt Service Coverage Ratio can be used to assess the feasibility of debt restructuring plans.
  • The DSCR can be used to track the financial performance of companies over time.

Calculation of Debt Service Coverage Ratio (DSCR)

Now that we have covered what is Debt Service Coverage Ratio (DSCR), it’s important to understand how it is calculated.

DSCR Formula

To calculate the DSCR, you need two key numbers: net operating income and total debt servicing. Net operating income is the revenue a company generates after subtracting specific operating expenses, excluding taxes and interest payments. It’s commonly referred to as earnings before interest and tax (EBIT).

Now, let’s have a look at the debt-service coverage ratio formula. 

DSCR= Net Operating Income/ Total Debt Service

where:

Net Operating Income=Revenue−COE

COE=Certain operating expenses

Total Debt Service=Current debt obligations

How to Calculate Debt Service Coverage Ratio (DSCR) in Excel?

Before calculating the debt service ratio, in Excel or Google Spreadsheet, we must first create the column and row heading names.

Step-1:

Write the heading and the given financial information of a company in the way shown below: 

  • B2 = Company Name
  • C2 = Net Operating Income
  • D2 = Total Debt Service
  • E2 = DSCR
  • B3, B4, and so on will be the locations of the company names

Step-2:

Write the data for net operating income and total debt service ratio in the assigned columns of the table.

Step-3:

To Calculate DSCR, apply the debt service coverage formula in Excel

  • The DSCR formula is as follows: Net Operating Income / Total Debt Service.
  • Place your cursor in cell E3.
  • The formula in Excel will begin with the equal sign(=).
  • Type the DSCR formula in cell E3 as follows: =C3/D3
  • Press Enter or Return on your keyboard

Refer to the screenshot below:

Step-4

Once you’ve pressed enter, the result will be automatically displayed in the E2 column as shown below:

As a result of the calculation, we can see that Company XYZ Ltd generates enough net operating income to cover its debt obligations by 5 times in one year. This pictures a DSCR ideal ratio. 

Interpreting DSCR Ideal Ratio – Analysis

If the standard DSCR calculated for a company is 1 or more, it suggests that the company has a surplus of cash flow beyond its debt requirements. When the figure equals 1, the organization earns precisely what it needs to repay its outstanding loans. At last, if the ratio is below that 1, signifies that the company’s net operating income is insufficient to cover its debt payments indicating financial strains.

Thus, a DSCR of more than 1 is considered as DSCR ideal ratio.

Example of Debt Service Coverage Ratio (DSCR)

Let’s consider a hypothetical scenario where a real estate developer, ABC Developers, is seeking a mortgage loan from a local bank. We will calculate the DSCR using the formula and provide an overall calculation.

Here are the details for ABC Developers:

  • Net Operating Income (NOI): ₹1,50,00,000 per year
  • Debt Service Payment: ₹1,00,00,000 per year (including both principal and interest)

To calculate the Debt Service Coverage Ratio, we will use the DSCR formula:

DSCR = Net Operating Income / Debt Service Payment

Plugging in the values:

DSCR = ₹1,50,00,000 / ₹1,00,00,000

DSCR = 1.5

In this scenario, the DSCR for ABC Developers is 1.5. This means that the company generates 1.5 times the income needed to cover its debt obligations. A DSCR greater than 1 indicates that the company has sufficient income to meet its debt payments, which is generally viewed positively by lenders.

Please note that this is a simplified example, and in practice, additional factors and expenses would be considered when calculating the DSCR.

What are the 3 Common Mistakes When Calculating the DSCR?

When calculating the dratio (DSCR), it’s important to avoid common mistakes that can impact the accuracy and reliability of the ratio. Here are three common mistakes to watch out for:

  • Incorrect inclusion of principal repayment amount: The DSCR should include the interest portion of the debt service payment, but not the principal repayment amount. Including the principal repayment in the calculation can artificially inflate the cash flow available for debt service and lead to an inaccurate DSCR.
  • Overlooking Capital Lease Expenses: Capital lease expenses should be included when calculating the DSCR as they represent contractual obligations similar to interest payments. Failing to account for capital lease expenses can result in an underestimated debt service requirement and an inflated debt service coverage ratio.
  • Confusing EBITDA with EBIT: EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) and EBIT (Earnings Before Interest and Taxes) are both measures of a company’s profitability, but they differ in the expenses they include. When calculating the DSCR, it’s crucial to use EBIT, which excludes non-operating expenses and provides a more accurate representation of a company’s ability to service its debt.

Interest Coverage Ratio vs. Debt Service Coverage Ratio (DSCR)

Interest Coverage Ratio and Debt Service Coverage Ratio (DSCR) are two important financial metrics used to assess a company’s ability to meet its obligations. While they both provide insights into a company’s financial health, they focus on different aspects of debt repayment. 

Therefore, some of the key difference points are listed below:

FeatureInterest Coverage Ratio (ICR)Debt Service Coverage Ratio (DSCR)
DefinitionMeasures the number of times that a company’s earnings before interest and taxes (EBIT) can cover its interest expensesMeasures the ability of a company to generate enough cash to cover its debt service obligations, including interest, principal, and lease payments
FormulaICR = EBIT / Interest ExpenseDSCR = Operating Income Available for Debt Service / Total Debt Service
What it measuresAbility to cover interest expensesAbility to cover debt service obligations
Typical range1.5-21.25-1.5
Higher is betterYesYes
LimitationsDoes not consider principal paymentsDoes not consider changes in working capital requirements
UsesLending decisions, investment decisions, debt restructuringLending decisions, investment decisions, debt restructuring, performance measurement

What are the Advantages & Disadvantages of DSCR?

Let’s have a look at the advantages and disadvantages of DSCR. 

Advantages

  • DSCR considers all debt service obligations, including interest, principal, and lease payments. This makes it a more comprehensive measure of a company’s financial health than other ratios, such as the interest coverage ratio (ICR).
  • The DSCR ratio formula  is relatively simple, and the results are easy to understand.
  • Debt service coverage ratio is a widely used measure of financial health, which means that it is easy to compare companies to each other. 

Disadvantages

  • The debt service coverage ratio can be volatile, as it is affected by changes in operating income and debt service obligations. 
  • It does not consider changes in working capital requirements. This means that a company with a high DSCR could still experience financial difficulty if its working capital requirements increase unexpectedly.

To Wrap It Up…

The Debt Service Coverage Ratio (DSCR) is a widely employed financial ratio that evaluates a company’s ability to meet its debt payments. It compares the company’s operating income to its debt obligations, including both principal and interest payments. The DSCR ratio formula serves as a valuable tool for lenders and external parties to gauge whether a company generates sufficient income to fulfil its financial obligations and helps in mitigating risk when determining loan terms.

FAQs

1. What is the debt service coverage ratio meaning?

The DSCR full form is Debt Service Coverage Ratio. This is a financial ratio that evaluates a company’s financial health. Based on the debt service coverage ratio, the investors/lenders can decide whether they want to invest or lend to the company.

2. What Is a good DSCR?

A “good” DSCR depends on the company’s industry, competitors, and growth. However, after applying the DSCR formula, if the ratio is 1 or more it is considered a DSCR ideal ratio.

3. Why is the DSCR important?

The debt service coverage ratio is a commonly used metric when companies and banks negotiate loan contracts.  It is important because it measures a company’s ability to generate enough cash to meet its debt obligations.

4. When should you calculate DSCR?

You might need to consider calculating DSCR in some situations. This could include when you are considering lending money to a company, investing in a company, and when a company is considering restructuring its debt.