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Debt service coverage ratio (DSCR) essentially calculates the repayment capacity of a borrower. DSCR less than 1 suggests the 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.
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. We will understand the formula and its calculation below.
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 a 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 viewpoint of the financing authority as it indicates a repaying capability of the entity taking a 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 a 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)
Noncash expenses (e.g. Depreciation, Miscellaneous expenses are 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.
It is stated and explained below:
PAT + Interest + Lease rental + Non-cash expenses
Installment (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 an absence of the profit and loss statement, we can also find it on 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.
The amount which is paid or payable for the financial year under concern on the loan is taken.
Noncash 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 noncash 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.
It is the amount paid or payable on the loan for the financial year under review. It includes the payment towards principal and interest for the financial year.
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 DSCR is analyzed and interpreted properly. 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.
The 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 a 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 a loan. Increasing the term of the loan will reduce the denominator of the ratio and thereby enlarge the ratio to greater than 1.