Debt service coverage ratio (DSCR) essentially calculates the repayment capacity of a borrower. DSCR less than 1 suggests inability of firm’s profits to serve its debts whereas a DSCR greater than 1 means not only serving the debt obligations but also the ability to pay the dividends.
Debt Service Coverage ratio (DSCR), one of the leverage / coverage ratios, calculated in order to know the cash profit availability to repay the debt including interest. Essentially, DSCR is calculated when a company / firm takes loan from bank / financial institution / any other loan provider. This ratio suggests the capability of cash profits to meet the repayment of the financial loan. DSCR is very important from the view point of the financing authority as it indicates repaying capability of the entity taking loan.
Just a year’s analysis of DSCR does not lead to any concrete conclusion about the debt servicing capability. DSCR is relevant only when it is seen for the entire remaining period of loan.
How to calculate Debt Service Coverage Ratio?
Calculation of DSCR is very simple. To calculate this ratio, following items from the financial statement are required:
- Profit after tax (PAT)
- Non cash expenses (e.g. Depreciation, Miscellaneous expenses written off etc.)
- Interest for the current year
- Instalment for the current year
- Lease Rental for the current year
Sometimes, these figures are readily available but at times, they are to be determined using the financial statements of the company / firm. Formula for DSCR is stated as follows:
PAT + Interest + Lease rental + Non cash expenses
Instalment (Interest + Principal repayment) + Lease Rental
- Profit after tax (PAT): PAT is generally available readily on the face of the Profit and loss account. It is the balance of the profit and loss account which is transferred to the reserve and surplus fund of the business. Sometimes, in absence of the profit and loss statement, we can also find it from the balance sheet by subtracting the current year P/L account from the previous year’s balance, which is readily available under the head of reserve & surplus.
- Interest: The amount which is paid or payable for the financial year under concern on the loan taken.
- Non cash expenses: Non cash expenses are those expenses which are charged to the profit and loss account for which payment has already been done in the past years. Following are the non cash expenses:
- Writing off of preliminary expenses, pre-operative expenses etc,
- Depreciation on the fixed assets,
- Amortization of the intangible assets like goodwill, trademark, patent, copyright etc,
- Provisions for doubtful debts,
- Deferment of expenses like advertisement, promotion etc.
- Instalment amount: The amount which is paid or payable for the financial year under review for the loan taken. It includes the payment towards principal and interest for the financial year.
- Lease Rental: The amount of lease rent paid or payable for the financial year.
Interpretation of debt service coverage ratio:
Just calculating a ratio does not serve the purpose till it is not interpreted in the correct sense. The result of a debt service coverage ratio is an absolute figure. Higher this figure better is the debt serving capacity. If the ratio is less than 1, it is considered bad because it simply indicates that the profits of the firm are not sufficient to service its debt obligations.
Acceptable industry norm for a debt service coverage ratio is between 1.5 to 2. The ratio is of utmost use to lenders of money such as banks, financial institutions etc. There are two objectives of any financial institution behind giving loan to a business viz. earning interest and not letting the account go bad.
Let’s take an example where the DSCR is coming to be less than 1, which directly indicate negative views about the repayment capacity of the firm. Does this mean that the bank should not extend loan? No, absolutely not. It is because the bank will analyze the profit generating capacity and business idea as a whole and if the business is strong in both of them; the DSCR can be improved by increasing the term of loan. Increasing the term of loan will reduce the denominator of the ratio and thereby enlarge the ratio to greater than 1.
- Advantages and Application of Ratio Analysis
- Return on Equity (ROE)
- Functions of Financial Management Aimed to Achieve the Goal of Profit and Wealth Maximization
- Common Size Financial Statements
- Capital Structure Theory - Modigliani and Miller (MM) Approach
- Capital Structure Theory - Traditional Approach
- Capital Structure Theory - Net Operating Income Approach