What is the Debt Service Coverage Ratio?
The debt service coverage ratio (DSCR) is a financial ratio that assesses a company’s ability to service its debt.
If the company has sizable capital expenditures (CapEx), you can calculate DSCR after deducting capital expenses. You can use the following formulas for calculating DSCR:
Total debt service (TDS) is the sum of all short-term liabilities payable within the period, interest expenses, and the principal amount. Interest expenses include the interest for both the short-term and long-term obligations. The portion of long-term liabilities added in TDS is the current portion of the principal to be paid. Here’s the formula for calculating TDS:
Total debt service = short term liabilities + current portion of long term liabilities + interest expenses
The difference between DSCR and the interest coverage ratio is that the interest coverage ratio only covers the interest expenses. In reality, cash outflows include the principal amounts too. DSCR gives a more realistic picture of the company’s ability to meet its obligations.
When DSCR is used to compare different firms, you can use EBIT (earnings before interest and taxes) instead of relying on net operating income. Taxes complicate the calculation of TDS because interest is tax-deductible while repayment of the principal amount is not.
As mentioned earlier, DSCR indicates a company’s ability to fulfill its debt obligations. A DSCR of less than 1 implies that the company has negative cash flow. The borrowers may be unable to service the debt without borrowing additional money or raising capital through some other means.
Even having a figure slightly above 1, like 1.1 for example, makes it risky. A slight deviation in the expected cash flow affects the company’s ability to service debt. DSCR is also taken into account when a company is considering a leveraged buyout.
Bank loan officers also rely on DSCR to decide whether to issue a loan. There is no rule that states a company has to have a certain DSCR to obtain a loan. It’s dependent on the risk appetite of the bank and macroeconomic conditions.
Debt is rarely desirable for most investors, but companies often raise capital through debt when other means are more costly. Companies can take on debt as part of prudent tax planning. Debt obligations must be serviced promptly; otherwise, it will compound and can even lead to bankruptcy.
Even in bankruptcy and the sale of company assets, debt is always serviced first. Shareholders only have a claim to what’s left after every other obligation is met. For that reason alone, investors should consider a company’s debt service coverage ratio when evaluating potential investment opportunities.