Debt-Service Coverage Ratio (DSCR): How to Use and Calculate It

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Understanding Debt Service Coverage Ratio For Business Loans

The full form of DSCR is Debt Service Coverage Ratio, a metric of a company’s “coverage” bucket during its analysis. DSCR calculation applies to various financial spheres and sectors, particularly personal, government, and corporate. Lenders, investors, financial analysts, and advisors use this ratio to determine the amount an entity possesses to meet its current cash obligations and requirements on credit. Simply put, DSCR represents an individual’s, firm’s, or project’s capacity to repay its current liabilities using its income sources.

The DSCR formula calculates the ratio by dividing a company’s net operating income by its debt service, including interest and principal.

The following sections will discuss the DSCR ratio and explain how to calculate the debt service coverage ratio.

What Is Debt Service Coverage Ratio (DSCR)?

The Debt Service Coverage Ratio, or DSCR or DSC ratio, is a credit metric that indicates a company’s ability to cover its annual principal and interest obligations using its operating cash flow. Since the DSCR ratio formula also includes a company’s principal obligations in its denominator, it is an extremely useful metric for reducing term debt.

The debt coverage ratio includes all the existing debt an individual or company is paying and the additional loans they seek. A company’s Annual Net Operating Income and Total Debt service are the major components for understanding the DSCR meaning.

Components of the Debt-Service Coverage Ratio

The two main components of the debt-service coverage ratio formula are net operating income and total debt service. Those who want to learn how to calculate DSCR ratio can divide the net operating income by its debt service. Let’s understand them better.

Net Operating Income (NOI): Net Operating Income or NOI is an entity’s revenue minus operating expenses, excluding interest and tax payments. Usually, it is equal to the Earnings Before Interest and Tax (EBIT).

Total Debt Service (TDS): The Total Debt includes a company’s current debt obligations, including principal, interest, lease payments, and sinking funds during a year. The balance sheet includes short-term loans and the outstanding balance of long-term loans.

Also Read: Difference Between Primary Security and Collateral Security

How to Calculate Debt Service Coverage Ratio (DSCR)?

Want to learn how to calculate debt service coverage ratio? Follow this stepwise procedure:

1. Determine the Net Operating Income (NOI)

To calculate the NOI, subtract a company’s capital expenditure and operating expenses from its gross profit. More complex calculations also consider EBITDA when calculating the NOI. Here is the formula to calculate the Net Operating Income:

NOI = Gross profit - Operating expenses

2. Calculate Total Debt Service (TDS)

The Total Debt Service includes both interest and principal loan payments. The formula to calculate the TDS is

Total debt service = Principal loan payments + Interest on loan

3. Divide NOI by TDS to get DSCR

Use this DSCR ratio formula to calculate the DSCR:

DSCR = Net Operating Income / Total Debt Service

An average DSCR above 1.5 is good. For instance, a company with a DSCR of 1.5 indicates sufficient income to cover its debt obligations.

What is a Good DSCR ratio?

A debt service coverage ratio of 1.5 or higher is an ideal DSCR ratio. A DSCR of 1 indicates that all the EBITDA goes straight to debt. The company has nothing left to pay taxes, reinvest in the business, or pay dividends.

What are the Advantages & Disadvantages of DSCR?

Let’s look at the advantages and disadvantages of DSCR:

Advantages	Disadvantages
DSCR calculation over a period helps understand a company's financial trend better	It may not fully incorporate a company's finances as some expenses (i.e., taxes) may be excluded
Useful in comparing the operational efficiency of companies	Heavily relies on accounting guidance that varies from actual cash needs at different times
Includes broad financial categories, principal repayments, and other ratios	The DSCR calculation formula is more complex than other financial ratios
Provides a comprehensive analysis of a company's finances on an annual rolling basis	Though debt and loans are rooted in obligatory cash payments, DSCR is partially calculated on accrual-based accounting guidance.

Factors Influencing DSCR

Several factors influence a company's debt service coverage ratio, including the NOI and TDS. Factors affecting the NOI include the company's operating income, interest rates, debt structure, non-operating income and expense, business cycles, etc. Besides these, factors influencing the Total Debt Service include operating costs, revenue volatility, loan terms and conditions, depreciation, amortisation, remuneration, capital expenditures, etc.

By identifying the key drivers affecting DSCR, companies can enhance their financial status and make informed borrowing decisions. Lenders may also use this metric to determine their lending activities. Understanding these determining factors gives borrowers and lenders a deeper insight into a company's debt coverage ratio. Based on that, they can analyse these factors and assess the company’s overall financial situation and sustainability.

Also Read: Difference Between Guarantor and Co-Borrower

Limitations of DSCR

One major limitation of DSCR is that it largely depends on a company’s Net Operating Income, EBIT, or EBITDA.

Another limitation is that it primarily relies on accounting guidance. Although loans and debt are obligatory expenses, the debt service coverage ratio calculator partially calculates the DSCR using accounting guidance based on accrual. Therefore, reviewing a company’s GAAP-based financial statements and stipulating fixed payments becomes inconsistent.