Last week, I started a post on the Debt management guide using the Interest Coverage Ratio (ICR) and how companies, business owners, lenders, and borrowers use the ratio to make decisions about debt. This post is a continuation of another financial ratio under the coverage category called the Debt-Service Coverage ratio (DSCR).
Small business loan applications can be stressful. But if you understood exactly what lenders were searching for, it would not be so horrible, right? Your debt service coverage ratio (DSCR) is one of the key criteria used to make lending choices.
But what exactly is the DSCR, and how can you determine what it is for you?
Everything you need to know about the debt service coverage ratio (DSCR) will be covered in this post. You will learn what a debt service coverage ratio (DSCR) is, how to calculate it, what a good DSCR looks like, how to improve it, and other things.
What Is the Debt-Service Coverage Ratio (DSCR)?
A fundamental measure of a company’s financial health is the debt service coverage ratio, which all business owners should be aware of. The debt-service coverage ratio is relevant to personal, public, and corporate finance. In corporate finance, the debt-service coverage ratio (DSCR) is a gauge of a company’s available cash flow to satisfy current debt commitments. Investors may see from a company’s DSCR whether it generates enough revenue to cover its debts. Simply, it measures the relationship between your business’s income and its debt.
The debt service coverage ratio (DSCR) is a key measure of a company’s ability to repay its loans, take on new financing and make dividend payments. It is one of three metrics used to measure debt capacity, along with the debt-to-equity ratio and the debt-to-total assets ratio.
The Debt Service Coverage Ratio (DSCR) is one metric within the “coverage” bucket when analysing a company. Other coverage ratios include EBIT over Interest (or something similar, often called Times Interest Earned or Interest Coverage ratio (ICR)), as well as the Fixed Charge Coverage Ratio (FCC).
Coverage measures are never taken in isolation when analysing a company; they are always used in conjunction with other categories of credit metrics like leverage (Debt-to-Equity, Funded Debt-to-EBITDA, etc.) and liquidity (Current Ratio and Quick Ratio).
It is a credit metric used to understand how easily a company’s operating cash flow can cover its annual interest and principal obligations. The Debt Service Coverage Ratio incorporates principal obligations in the denominator, making it a highly helpful indicator when a business borrower has reducing term debt in its capital structure (i.e., monthly or annual principal repayments).
Understanding Debt-Service Coverage Ratio (DSCR)
A common measure of a company’s financial health, particularly for companies that are heavily leveraged and indebted, is the debt-service coverage ratio. The ratio contrasts a company’s operational revenue with all of its debt commitments, including principal repayments and some capital leasing contracts.
Different DSCR measures will be the focus of various lenders, stakeholders, and partners. Moreover, a company’s background, sector, product pipeline, and previous connections with lenders. While DSCR restrictions are frequently incorporated in loan agreements, external parties may be more sympathetic during seasonal operations when a company’s income is flexible.
DSCR is calculated on an annualized basis – meaning cash flow in a period over obligations in the same period. This is in contrast to leverage and liquidity, which represent a snapshot of the borrower’s financial health at a single point in time (usually period end).
In all adjustment scenarios, a higher DSCR is considered better than a lower one. Anything less than 1x (or 1:1) is considered very weak and suggests that a company owes more money to creditors (per year) than it generates in cash per year.
Most commercial banks and equipment finance firms want to see a minimum of 1.25x but strongly prefer something closer to 2x or more. Many small and middle-market commercial lenders will set minimum DSCR covenants at not less than 1.25x.
How to calculate Debt-Service Coverage Ratio (DSCR)
Net operating income and the total debt servicing of an entity are two requirements for calculating the debt-service coverage ratio. A company’s revenue minus certain operating expenditures (COE), excluding taxes and interest payments is the net operating income. This is often regarded as being equal to earnings before interest and taxes (EBIT).
DSCR = Net Operating Income / Total Debt Service
DSCR = (Cashflow +/- Adjustments) / (Interest + Principal)
Where: Net Operating Income = Revenue − COE = Cashflow +/- Adjustments
COE = Certain operating expenses or Adjustments
Total Debt Service = Current debt obligations = Interest + Principal
Please note, some calculations include non-operating income in EBIT. It is crucial to use uniform criteria when calculating DSCR as a lender, investor, or manager comparing the creditworthiness of several organizations, or when comparing various years or quarters. It is also crucial for borrowers to be aware that lenders may compute DSCR in slightly different ways.
Total debt service includes all interest, principal, sinking fund, and lease payments that are due in the upcoming year. Current debt obligations are also referred to as outstanding debt. This will appear as both short-term debt and the present share of long-term debt on a balance sheet.
Due to the fact that interest payments are tax deductible, but principal repayments are not, income taxes complicate DSCR calculations.
Therefore, the following calculation is a more precise method to determine total debt service:
TDS = (Interest × (1−Tax Rate)) + Principal
Where: TDS = Total debt service
Different lenders may slightly tweak how DSCR is calculated. For example, some may use operating income, EBITDA, or EBIT as the numerator depending on the need.
Debt Service Coverage is sometimes calculated using EBITDA as a proxy for cash flow. Adjustments will vary depending on the context of the analysis, but the most common DSCR formula is
DSCR = (EBITDA – Cash Taxes) / (Interest + Principal)
Where: EBITDA = Earnings Before Interest, Tax, Depreciation, and Amortization
Principal = The total amount of loan principal due within the measurement period (often expressed as the current portion of long-term debt or CPLTD).
Interest = The total aggregate amount of interest due within the measurement period, calculated on both the current portions and the non-current portions of long-term debt.
Cash Taxes = The proportion of total income tax that’s due in cash during the current measurement period.
In conclusion, let us look at the importance and benefits of the Debt Service Coverage Ratio (DSCR) to your business. There are two main factors that make the Debt Service Coverage Ratio (DSCR) significant:
- It demonstrates the strength of your company’s cash flow.
- It affects the likelihood that your company will be approved for a loan.
The Debt Service Coverage Ratio (DSCR is a useful tool for keeping tabs on the health and profitability of your company. You can determine whether your company can genuinely afford to make loan payments by calculating your DSCR before you begin looking for loans.
A high DSCR shows that your company makes enough money to cover loan payments while still turning a profit. A low DSCR suggests that you can experience loan payment difficulties or perhaps a cash flow deficit. If so, before taking on more debt, you might need to raise your DSCR.
Thus, before submitting a loan application, understanding your DSCR can assist you in doing a financial analysis of your company and assisting you in making a well-informed business decision.
The debt service coverage ratio is also crucial for lenders. One of the key factors that lenders consider when assessing your loan application is your DSCR.
The DSCR helps lenders:
- To determine how likely you are to make your loan payments on time each month.
- To take into account how much revenue cushion you have to make payments despite any changes in your cash flow.
- To assess how much credit to extend to you.
The debt service coverage ratio has a significant impact on loan decisions for small enterprises looking for capital. Your DSCR is used by lenders to estimate your borrowing capacity and whether you can afford to make on-time loan payments.
But more than that, your debt service ratio is a useful indicator of the financial stability and cash flow of your company. Your DSCR can show you how much money your business makes after paying off its debts and whether it makes sense financially to take out a loan. The better, the higher your DSCR.
On a final note, I advise you to consider your financial circumstances carefully before applying for a loan. Before you take out a loan, determine your DSCR, determine if you can afford to do so, and plan out exactly how you will utilize it. Debt service coverage ratios (DSCR) make it more crucial than ever to thoroughly research your lender’s criteria because each one calculates the DSCR in its own unique way. Do not forget to find out whether your lender has any requirements about the DSCR you must maintain during the loan’s term.
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Written by Hay-R-Hay