Debt Coverage Ratio FormulaDefined along with Formula & How to Calculate

Written By:
Lisa Borga

What is the Debt-Service Coverage Ratio (DSCR)?

The debt service coverage ratio is the ratio of net operating income to total debt service.

This ratio is useful for businesses, the government, and even individuals in determining whether or not they can meet their debts with the net income they generate.

It compares a business’s cash flow to its debt service payments. 

DSCR Ratio Formula

The debt-service coverage ratio formula is: 

DSCR = Net Operating Income/Total Debt Service 

This ratio helps to indicate whether or not a company will be able to meet its debts with its net operating income.

If a company’s DSCR is below one, it indicates that the company is not generating enough income to cover its debt-related obligations.

In contrast, if the company’s DSCR is greater than one, the company generates sufficient net operating income to meet its debt-related obligations. 

Computing Net Operating Income

DSCR compares a company’s net operating income to its total debt obligations. 

Operating income is the money remaining once operating expenses and cost of goods sold have been subtracted from revenue.

But, when using this equation, net operating income will be a company’s earnings before interest, amortization, taxes, and depreciation.

The following formula can be used to compute net operating income. 

Net Operating Income = Net Income + Interest + Non-cash Expense + Tax 

The amount of a company’s taxes will be added to the company’s net income in order to compute the net operating income.

This is done due to the fact that interest payments occur before tax payments.

Therefore, the cash a company has before paying interest will be used to pay interest and then taxes. 

Amortization and depreciation are not cash expenses and do not result in any cash flow.

Therefore, these expenses do not reduce the amount of cash a company has available to meet its debts.

This is the reason why the amount of both amortization and depreciation is added back into the company’s net income before computing net operating income. 

Computing the Total Debt Service

The total debt service of a business is its current debt obligations.

This would include any principal, interest, lease payments, or sinking funds that will be paid within a year.  

Total debt service is used as the denominator in the DSCR.

To calculate the total debt service, it is necessary to use the principal and the interest of the debt that will be serviced.

Here is the formula. 

Total Debt Service = Interest + Principal Repayments + Lease Payments 

Sometimes there are other items that will be a part of the total debt service, such as the current part of long-term debt or lease payments.

Operating income will be included as a part of earnings before interest and taxes.  

When investors or lenders compare the creditworthiness of different businesses, or a manager compares different operating periods by using DSCR, it is essential to use the same criteria in order for the comparison to be useful.

Also, borrowers should be aware that different lenders may compute the debt-service coverage ratio differently.

DSCR will consist of short-term debt as well as the current portion of long-term debt on the balance sheet. 

How DSCR Is Used

• DSCR allows investors and lenders to analyze the financial position of a company by evaluating its ability to pay its debts. If a lender or investor has this information for several companies, they can do a comparative analysis. 
• If DSCR is being computed for an industry that requires very large capital expenditures as a part of its usual business, the ratio will likely be below one. 
• The DSCR is more useful than a number of other debt-related ratios in determining a business’s ability to pay its debts since the ratio considers both principal and interest payments on the business’s outstanding debt. 
• When investors are looking at a company’s Debt-Service Coverage Ratio, it is important to consider that an unusually high DSCR is probably not good. A particularly high DSCR might mean a company is not making good use of its cash. A company should have a DSCR that is around the average for the industry. 
• It is important to make sure that if DSCR is going to be used to compare companies, they should be in the same industry or at least a similar industry or sector. 
• DSCR is often used by lenders when deciding whether or not to make a loan. 

Examples for Debt-Service Coverage Ratio

As an example, consider Company X. Here are some financial figures for 20XX. 

• Net Income = $700 million 
• Interest Expense = $70 million 
• Non-cash Expenses = $50 million 
• Tax Rate = 25% 
• Principal Payments = $25 million 
• Lease payments = $10 million 

First, we need to compute the Net Operating Income 

Here is the equation: 

Net Operating Income = Net Income + Interest + Non-cash Expense + Tax 

The taxes for Company X would be: 

$700,000,000 * .25 = $175,000,000 

Net Operating Income = $700,000,000 + $70,000,000 + $50,000,000 + $175,000,000  

Net Operating Income = $995,000,000 

Total Debt Service = Interest + Principal + Lease Payments 

Total Debt Service = $70,000,000 + $25,000,000 + $10,000,000 

Total Debt Service = $105,000,000 

Debt-Service Coverage Ratio = Net Operating Income/Total Debt Service  

Debt-Service Coverage Ratio = $995,000,000 / $105,000,000 

Debt-Service Coverage Ratio = 9.48 

The Debt-Service Coverage Ratio for Company X is above 1.

Therefore, the company has the amount of cash it needs to meet its debt obligations for the year being considered.

In this case, Company X possesses 9.48 times the cash it needs to meet its debt obligations. 

Debt-Service Coverage Ratio vs. Interest Coverage Ratio

The interest coverage ratio is a financial ratio that measures the ability of a company to pay the interest on its debts for a given period of time.

This ratio is typically calculated for a year. 

In order to compute the interest coverage ratio, a company’s earnings before interest and taxes are divided by the total interest payments that are due for the same time period.  

Interest Coverage Ratio = Earnings Before Interest and Taxes / Interest Expense 

The earnings before interest and taxes are also known as the operating profit or net operating income.

It is computed by subtracting the operating expenses and overhead of a company from its revenue.

This figure is the amount of cash a company has once its cost of goods sold and operating expenses have been covered.  

If the interest coverage ratio is below one, the company does not have sufficient net operating income to cover its interest payments.

In contrast, if the interest coverage ratio is above one, the company has sufficient net operating income to make its interest payments.

The ratio only indicates if a company has enough operating profit to make its interest payments, not to cover necessary principal payments.  

The debt-service coverage ratio analyzes a company’s ability to make principal and interest payments for a certain period.

DSCR is computed by dividing EBIT by the sum of the principal and interest payments for the period being considered.

Due to the fact that this ratio considers both principal and interest payments, it can give a more complete picture of a company’s financial position.  

Companies that have a debt-service coverage ratio below one do not have sufficient revenue to meet their minimum debt obligations.

This is a risky situation for a business to be in since if the company has a period of time in which it makes below-average income, it could fail to make the payments on its debt. 

Special Considerations

One limit in using the interest coverage ratio is the fact that it doesn’t fully analyze a company’s ability to cover its debt obligations.

Typically long-term debt will have requirements for amortization involving dollar sums that are similar to interest, and if a business does not fulfill the sinking fund requirement, it would be in default and could be forced into bankruptcy.

The fixed charge coverage ratio can be used as a way to try and measure a company’s repayment ability. 

Computing DSCR

The debt-service coverage ratio can be computed by dividing the net operating income by the total debt service.

The debt service consists of the principal and interest on a loan.

As an example, suppose a company’s net operating income is $250,000, and it has a total debt service of $175,000.

The company’s debt-service coverage ratio would be 1.43 

The Importance of DSCR

The debt-service coverage ratio is often considered by banks when a company is attempting to obtain a loan.

A bank might make maintaining a certain minimum DSCR a condition of a loan.

Then, if a company’s DSCR falls below the required minimum DSCR, it could be found to be in default of the loan.

Also, investors and analysts can use DSCR to help analyze a company’s financial health. 

What is a Good Debt-Service Coverage Ratio?

A good debt-service coverage ratio is not the same for every company.

It varies based on a company’s stage of growth and the industry it is in, as well as its competitors.

For example, a well-established company might be expected to have a higher DSCR than a company just starting out.

However, generally, a DSCR of greater than 1.25 is considered good.

In contrast, a DSCR that is below one could mean a company is having financial problems. 

Key Takeaways

• DSCR is the ratio of net operating income to total debt service. 

• The debt service coverage ratio is a useful metric for the government, businesses, and individuals. 
• The minimum debt service-service credit ratio required by a lender varies based on the condition of the economy. A lender might be more willing to accept a lower ratio in a growing economy.