What is the “Debt Service Coverage Ratio?”
The Debt service coverage ratio (DSCR) is a financial ratio commonly used by lenders to assess the ability of a company to meet its financial obligations i.e. its ability to use its operating income to meet all debt (short-term and long-term) related obligations that includes periodic or scheduled payment of interest and repayment of principal. A higher (lower) ratio indicates a greater (lower) ability of a company to meet its debt obligations.
Key Learning Points
- The DSCR can be computed using two formulas. The first one includes Capex and the second one excludes Capex;
- If a company has a DSCR of less than 1, there is a higher probability of default or bankruptcy;
- The DSCR of a company should be assessed only relative to the DSCR of companies in the same or similar industry; and
- Certain industries tend to have low DSCR, as they take massive capital expenditure or significant amounts of debt.
Debt Service Coverage Ratio (DSCR) – Formula and Salient Points
A company’s DSCR can be computed by either of these two formulas:
DSCR = EBITDA/ Interest Expense + Principal (i.e. Total Debt Service)
DSCR = EBITDA – Capex/ Interest Expense + Principal (i.e. Total Debt Service)
EBITDA = Earnings before Interest, Tax, Depreciation and Amortization
Principal = Total of Short and Long-Term Debt Repayments
Interest Expense = Interest Payable on all Debt
Capex = Capital Expenditure
When Capex is excluded from EBITDA, it may provide a more accurate picture or the actual amount of operating income that is available to a company for meeting its debt repayment obligations as Capex is not expensed to the income account.
A high DSCR indicates that a company is generating adequate income to meet its debt related obligations and still making a profit. For example, if a company’s DSCR is 1.2, it means that it can meet its annual debt service related obligations 1.2 times with its net operating income.
If the DSCR is below 1, it suggests that a company is unable to service its debt and there is a higher probability of default or bankruptcy. If for example the DSCR is 0.6, it means that the company’s net operating income can only cover 60% of its annual debt service related obligations.
The DSCR is important for several reasons. Principally, it reflects how healthy is the cash-flow of a company, if it is generating enough income to qualify for a loan (for lenders, this is a key ratio to assess). It is also used to determine the company’s debt servicing ability and this ratio is commonly used in a leveraged buyout transaction (to assess or explore the debt capacity of the target company).
The DSCR of a company should also be evaluated only against the DSCR of companies in the same or similar sector or industry, and relative to the industry average in which it is operating.
It is important to note that certain industries undertake massive capital expenditure or traditionally use significant amounts of debt (companies in such sectors usually do not generate enough net operating income to service all their debt obligations due in a particular period). Consequently, they tend to have low DSCR i.e. below 1, which does not necessarily mean that companies operating in such industries are at high risk (i.e. a lower DSCR ratio does not always indicate that a company is at higher risk of defaulting or going into bankruptcy).
DSCR – Example
Given below is the calculation of DCSR (including Capex) and DCSR (minus Capex) of Company A. The calculations show that the DSCR in both cases is greater than 1. This company can repay or cover its debt service 1.81 times over its operating income (when including Capex) and 1.20 times over its operating income (when Capex is excluded).