Debt Service Coverage Ratio
The debt service coverage ratio (DSCR) has different interpretations in different fields. In corporate finance, for example, the debt-service coverage ratio can be explained as the amount of assessable cash flow to congregate the annual interest and principal payments on debt, not forgetting the sinking fund payments. On the other hand, as explained in Government finance, the debt-service coverage ratio refers to the requisite amount of export earnings for meeting up the annual interest and principal payments on the external debts of a country.
Personal finance, on the contrary, explains it as a ratio which is used by bank loan officers to determine income property loans. The ratio is considered to be ideal if it is above 1 thus indicating that the property is producing income which is sufficient to pay back its debts.
The formula used for calculating the debt service coverage ratio is:
DSCR = Net Operating Income / Total Debt Service
Generally, the debt service coverage ratio is calculated as -
DSCR = (Annual Net Income + Interest Expense + Amortization&Depreciation + Other discretionary and non-cash items like non contractual provided by the management)/ (Principal Repayment + Interest Payments + Lease Payments)
Thus, to calculate the debt service coverage ratio of a company or business entity, it is, at the first point, essential to calculate the net operating income of the company.
A debt service coverage ratio which is below 1 indicates a negative cash flow. For example, a debt service coverage ratio of 0.92 indicates that the company’s net operating income is enough to cover only 92% of its annual debt payments. However, in personal finance context, it indicates that the borrower would have to look into his/her personal income and funds every month so as to keep the project afloat. The lenders, however, usually frown on a negative cash flow while some might allow it if, in case, the borrower is having sound income outside.The debt service coverage ratio is, therefore, a benchmark used to measure the cash producing ability of a business entity to cover its debt payments. A higher debt service coverage ratio makes it easier to obtain a loan.