The debt service coverage ratio (DSCR) essentially calculates the repayment capacity of a borrower. DSCR less than 1 suggests the inability of a firm’s cash to serve its debts in time. Or that the firm will struggle in meeting its debt obligations. Whereas a DSCR of greater than 1 is considered healthy and 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), one of the coverage ratios, calculated in order to know the availability of cash profits to repay the principal and interest obligations. 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 available cash profits to meet the repayment of the financial loan and interest thereof timely. 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 seen for the entire or 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)
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.
It is stated and explained below:
|PAT + Interest+ Non-cash expenses|
|Installment (Interest + Principal repayment due during the year)|
Profit after tax (PAT)
PAT is generally available readily on the face of 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 an 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 which is payable for the financial year by the concern on the loans taken.
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. 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 is not getting 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.
It is the amount payable on the loan for the financial year under review. And it includes the payment towards principal 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. Because the result of a debt service coverage ratio is an absolute figure. Higher this figure better is the debt serving capacity of the entity. It shows sound financial position of the company. If the ratio is less than 1, it is considered bad because it simply indicates that the cash 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 for lenders of money such as banks, financial institutions etc. Objectives of any financial institution behind giving a loan to a business is earning interest and to make sure 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 indicate negative views about the repayment capacity of the firm. Does this mean that the bank should not extend 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 and if the business is strong in both of them; the DSCR can be improved by increasing the term of the loan. Increasing the term of the loan will reduce the denominator of the ratio and thereby enlarge the ratio to greater than 1.
Companies having higher DSCR can bargain for favorable terms for them, like lower rate of interest, less protective covenants or security etc. Truly for any loan this ratio is 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 Lease Rental Payments should also be included in this calculation ie that should be added to the numerator as well as denominator. We however, have a different view. Lease Rental can be a long term expenses but it is a rental expenses like any other expense and should not be considered as debt obligations. DSCR is for calculations of debt obligations. Of course, if it is a DPG arrangement then it will automatically becomes part of the Debt Obligations. Hence, we have not included lease payments/rentals while calculating DSCR.