Debt Service Coverage Ratio

Tags: cash flow, debt, debt service coverage ratio, EBIT, ebitda, financial ratio, Interest, net income
By: Dan
July 23, 2013

The debt service coverage ratio (DSCR) is a financial ratio that measures the company’s ability to pay their debts. In broad terms the DSCR is defined as the cash flow of the company divided by the total debt service.
A DSCR > 1.0 indicates that the company is generating sufficient cash flow to pay their debts. A DSCR < 1.0 should be a cause for concern because it indicates that the company is negatively cash flowing.

Debt Service Coverage Ratio formula:

DSCR calculation = EBIT divided by (interest + (principal/ 1-tax rate)
In some cases in calculating the debt service coverage ratio EBITDA is used instead of EBIT since EBITDA is a closer approximation of cash flow. When calculating the debt service ratio denominator leases should be included along with other debt service costs.

Debt Service Coverage Ratio (DSCR) example:

Assumptions:
Net Income = $643,800 Interest Expense = $240,000 Taxes = $331,655 Principal Payments = $300,000 Tax Rate = 34%
DSCR numerator = EBIT = $643,800 + $240,000 + $331,655 = $1,215,455
DSCR denominator = interest + (principal payments / (1-tax rate)) = $240,000 + ($300,000 / (1-34%) = $695,545
DSCR = $1,215,455 / $695,545 = 1.75

Uses of Debt Service Coverage Ratio:

The DSCR is used as a financial tool for trend analysis. By following the increase or decrease of the DSCR over time a company can determine if they are building liquidity in the business. Benchmarking the DSCR against other companies in similar industries is useful in setting goals for the corporation to attain.
Finally, the DSCR is often used in loan covenants for triggering a default if deteriorating financial results occur.