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In a nutshell, the Debt Service Coverage Ratio (DSCR) measures a company's ability to pay its debts with its current income.

Here's what DSCR is and how it works.

What Is Debt Service Coverage Ratio?

The DSCR is the ratio of a company's operating income to its debt payments. This is measured on an annual basis, so (for example) a company's Debt Service Coverage Ratio from 2018 would measure all of the company's income from that year against all the payments it made on debt in that same period.

This is expressed as a multiple of income to debt.

Calculating the Debt Service Coverage Ratio

The Debt Service Coverage Ratio measures how well a company can service its debt with its current revenue. Analysts can use several different variants of the basic formula to calculate DSCR, depending both on the analyst's practice and on the firm under review.

The most common formula is:

• EBIT / Total Debt Service = DSCR

In the alternative, some analysts will use:

• EBITDA / Total Debt Service = DSCR

Finally, some analysts calculate this as:

• EBITDA - CAPEX / Total Debt Service = DSCR

The final ratio, as discussed above, is expressed as a multiple of the firm's income to debt ratio.

Breaking Down the Debt Service Coverage Ratio Calculation

Here are the core terms involved in calculating a Debt Service Coverage Ratio.

EBIT and EBITDA

This is the measure of a company's cash flow.

EBIT stands for "earnings before interest and taxes." It measures a firm's basic operating income, its revenue after paying for all basic expenses but before paying debt interest and taxes.

EBITDA stands for "earnings before interest, taxes, depreciation and amortization." It measures the cash flow of a business, its revenue after paying for basic expenses but before paying taxes, debt interest and capital asset depreciation.

Each is a basic statement of the firm's post-expense income.

CAPEX

This is the net amount of capital expenditures a company has made within this accounting period. A capital expenditure is an outlay of money to acquire or improve capital assets such as buildings and machinery.

This is the money that a firm has spent on its major, institutional investments. In some cases, analysts will exclude it from a firm's income for the purposes of a DSCR calculation. This is particularly common for capital-intensive industries, such as agriculture or construction, which may have large costs for new, upgraded or replacement capital expenditures.

Total Debt Service

This is the total amount of payments due on both short-term and long-term debt during the period of analysis. It includes both interest and principle.

Most analysts also include lease payments due during the period of analysis. This is particularly the case for industries with particularly large rental expenses such as in real estate and equipment.

Example of the Debt Service Coverage Ratio

For this example we will use a simplified DSCR calculation.

Company A has the following income:

  • Revenue: $100,000
    • Operating Expenses and Costs of Goods: -$20,000

EBIT: $80,000

This is Company A's cash flow after it pays for its basic operating expenses. It excludes the company's taxes or payment on interest, giving us a basic statement of operational cash flow.

Company A has the following debt:

  • A 2-year loan: $100,000
    • Annual payment: $60,000 per year, including interest
  • A 10-year loan: $10,000
    • Annual payment: $1,500 per year, including interest

Total annual debt payment: $61,500 per year

Company A, therefore, has the following Debt Service Coverage Ratio:

• DSCR = $80,000 / $61,500 = 1.3x

Reading the Debt Service Coverage Ratio

The DSCR measures how much of a company's debt it can pay with its ongoing revenue. In the case above, for example, Company A has 30% more operating cash than it needs to pay its annual debt payments.

It is written with an "x" after it to signify how many times over the company can pay its debts. In the case of Company A, this firm has enough net revenue to pay its debts 1.3 times over.

There are three forms of DSCR result:

• Less than one, DSCR = 0.X

The company has negative operating capital to debt service. It makes less money than it needs to pay its annual debts, and will have to draw on pools of capital or outside lending to prevent business disruption.

• Exactly one, DSCR = 1.0

The company has exactly enough money to pay its debts. It is not at risk of insolvency, but it also has little or no excess capital for investment or to cushion against a downturn.

• More than one, DSCR = 1.X

The company has more annual income than it needs to cover its debt payments. The higher the DSCR rating, the more comfortably the company can cover its obligations.

As a general rule, a DSCR of 1.15 - 1.35 is considered good.

Using the Debt Service Coverage Ratio

The main purpose of a DSCR is to assess a company's creditworthiness. Banks and other lending institutions use it alongside credit history while deciding whether to extend a loan, or may also use it when structuring a leveraged buyout.

In both cases the DSCR assesses how well a company can afford to pay a new obligation. A low ratio indicates that the company may not have enough excess income to make payments on new debt.

A high ratio indicates that the company has plenty of extra cash coming in, making it a good subject for credit. Except during times of particularly loose lending, banks generally require a good DSCR before extending a loan (as noted above, between a minimum of 1.15 - 1.35).