The debt service coverage ratio (DSCR) essentially calculates the repayment capacity of a borrower. DSCR less than 1 suggests a firm’s cash inability to serve its debts in time. Or that the firm will struggle in meeting its debt obligations. Whereas a DSCR of greater than one is considered to be healthy. It means that the company will be able to serve all its debt obligations smoothly.
Definition of DSCR
DSCR is a ratio of cash available to cash required for debt servicing. In other words, it is the ratio of the sufficiency of cash to repay the debt in time. Now we will try to understand the formula and its calculation below.
Debt Service Coverage Ratio (DSCR), is one of the coverage ratios, that is calculated to know the availability of cash profits to repay the principal and interest obligations. Essentially, DSCR’s calculation is when a company/firm takes a loan from a bank / financial institution / any other loan provider. This ratio suggests the capability of available cash profits to meet the repayment of the financial loan and interest promptly. DSCR is very important from the viewpoint of the financing authority because it indicates the repaying capability of the entity taking a loan. Moreover, just a year’s analysis of DSCR does not lead to any concrete conclusion about the debt servicing capability. Hence, DSCR is relevant only when it is for a loan’s entire or remaining period.
How to Calculate Debt Service Coverage Ratio?
The calculation of DSCR is very simple. To calculate this ratio there is a requirement of the following items from the financial statement:
Profit after tax (PAT)
Non-cash expenses (e.g., Depreciation, Miscellaneous expenses are written off, etc.)
Interest for the current year
Installment 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.
Refer to How is DSCR Calculated? for more details.
The formula is as follows:
FULL RATIO ANALYSIS (32 RATIOS)
We have covered the complete ratio analysis – its significance, application, importance, and limitations, and all 32 RATIOS of ratio analysis that are structured and categorized into 6 important heads.
|DSCR = (PAT + Interest+ Non-cash expenses) / Installment (Interest + Principal repayment due during the year)|
You can also use our DSCR Calculator for a quick calculation.
Profit after Tax (PAT)
PAT is generally available readily in the Profit and loss account. And it is the balance of the profit and loss account which is transferred to the reserve and surplus fund of the business. Therefore, sometimes, in the absence of the profit and loss statement, we can also find it on the balance sheet by subtracting the current year’s P/L account from the previous year’s balance, which is readily available under the head of reserve & surplus. Of course, in this derived methodology, we also need to add back all the distribution of PAT like dividends to equity and preference shareholders.
The amount payable for the financial year by the company on the loans taken.
Non-cash expenses are those expenses charged to the profit and loss account for which payment has already been made in the past years. And the logic behind adding all these expenses is that cash outflow for all these expenses has already taken place in the past. Further, these expenses are simply charged to the Profit and Loss Account as per the accounting treatment of those expenses. Hence, the cash flow does not get affected by charging these expenses. 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 an advertisement, promotion etc.
The amount payable on the loan for the financial year is under review. And it includes the payment towards principal for the financial year.
Interpretation of DSCR
Calculating a ratio does not serve the purpose until analysis and interpretation of DSCR are correct. Because the result of a debt service coverage ratio is an absolute figure, the higher this figure is, the better is the debt serving capacity of the entity. It shows the sound financial position of the company. If the ratio is less than 1, it is considered harmful because it simply indicates that the firm’s cash is not sufficient to service its debt obligations.
The acceptable industry norm for a debt service coverage ratio is between 1.5 to 2. The ratio is of utmost use for money lenders such as banks, financial institutions, etc. Objectives of any financial institution behind giving a loan to a business are earning interest and ensuring that the principal amount remains secured and comes back as planned.
Let’s take an example where the DSCR is coming to be less than 1, which directly indicates negative views about the repayment capacity of the firm. Does this mean that the bank should not extend the loan? No, absolutely not, and as we say, one indicator is not enough to draw all the conclusions. The bank needs to carefully evaluate and analyze the profit-generating capacity and business idea as a whole. If the business is strong in both of them, the DSCR can be improved by increasing the loan term. Increasing the loan term will reduce the denominator of the ratio and thereby enlarge the ratio to greater than 1.
Companies with higher DSCR can bargain for favorable terms, like a lower rate of interest, less protective covenants or security, etc. Truly for any loan, this ratio is a must. It finally says that whatever obligations the company is committing, the resources are enough to meet those obligations when the DSCR is more than 1.
Note: Some writers and teachers suggest that it should also include Lease Rental Payments in this calculation, i.e., its addition should be to the numerator and the denominator. We, however, have a different view. Lease Rental can be a long-term expense, but the rental expense is like any other expense. And therefore, it is not a debt obligation. DSCR is for calculations of debt obligations. Of course, if it is a DPG arrangement, it will automatically become part of the Debt Obligations. Hence, we have not included lease payments/rentals while calculating DSCR.
Visit Coverage Ratios for learning about its other types.