The DSCR is made up of 2 main parts: net operating income and total debt service. To figure out the DSCR, you simply divide the net operating income by the total debt service. Let us break these down:
- Net operating income: This is the money a company makes from its regular business activities after taking away operating costs but before interest and taxes are deducted. It is usually the same as Earnings Before Interest and Tax (EBIT)
- Total debt service: This includes all the debt payments a company needs to make in a year, such as loan repayments, interest, lease payments, and sinking fund contributions. On the balance sheet, this will show up as short-term loans and the remaining balances of long-term loans. A company’s business environment can influence how debt is structured and managed.
Debt service coverage ratio formula
The formula for the debt service coverage ratio (DSCR) uses a company’s net operating income and its total debt payments.
Net operating income is the company’s revenue minus certain operating expenses (COE), and it does not include tax or interest costs. COE can include items such as salaries, utilities and depreciation. Net operating income is often treated as the same as earnings before interest and taxes (EBIT).
DSCR = Net Operating Income ÷ Total Debt Service
Where:
- Net Operating Income = Revenue – COE
- COE = Certain operating expenses (which may include depreciation)
- Total Debt Service = Current debt obligations
Total debt service includes all debt payments due within the year—such as interest, principal, sinking fund payments and lease payments. This covers short-term debt as well as the current portion of long-term loans.
Income tax can make DSCR calculations more complex because interest is tax-deductible but principal repayments are not. A more accurate way to calculate total debt service is:
TDS = (Interest × (1 – Tax Rate)) + Principal
Where:
How to calculate the debt service coverage ratio (DSCR)?
To calculate the DSCR, follow these steps:
- Determine the net operating income: Gather the company’s net operating income, which is the income remaining after all operating expenses are deducted from total revenues.
- Identify the total debt service: Total the company’s debt obligations, which includes both principal and interest payments for the period.
- Apply the formula: Divide the net operating income by the total debt service. The resulting number is the DSCR.
- Interpret the ratio: A ratio greater than 1 means the company generates sufficient income to cover its debt payments, while a ratio below 1 suggests that the company may struggle to meet its debt obligations. The cost of capital also impacts how companies evaluate their debt service coverage ratio and funding strategies.
An example for calculating DSCR
Here are the two distinct examples of DSCR for two different sectors:
1. Real estate
A real estate company generates Rs. 10 lakhs in rental income annually and has Rs. 6 lakhs in debt service. The DSCR will be calculated as Rs. 10 lakhs/Rs. 6 lakhs = 1.67, indicating the company can cover its debt 1.67 times with its rental income.
2. Income one below one
A manufacturing company earns Rs. 15 lakhs in net operating income and has a debt service of ₹12 lakhs. The DSCR will be Rs. 15 lakhs/Rs. 12 lakhs = 1.25, showing that the company has sufficient income to cover its debt.
Importance of DSCR in Finance
- Loan eligibility assessment: Lenders use DSCR to determine whether a business generates enough income to cover its debt obligations before approving a loan.
- Indicator of financial stability: A higher DSCR reflects better financial health, helping businesses gauge their ability to manage existing and future liabilities.
- Investor decision-making: Investors rely on DSCR to understand the level of risk associated with funding a company, particularly its debt-handling capability.
- More comprehensive than ICR: Unlike the Interest Coverage Ratio, which only considers interest payments, DSCR evaluates the company’s capacity to service total debt, including both principal and interest.
Check your pre-approved business loan offer to explore what financing options may be available based on your DSCR.
Limitations of DSCR
- Dependence on income metrics: DSCR heavily relies on figures such as Net Operating Income, EBIT, or EBITDA, which can fluctuate and may not always provide an accurate representation of cash flow.
- Accounting-based calculations: DSCR calculations primarily depend on accounting standards, which follow accrual-based methods. As debt obligations are actual cash expenses, using accrual accounting can sometimes lead to discrepancies between the calculated DSCR and the company’s real cash position.
What is a good or bad debt service coverage ratio?
A good DSCR is generally considered to be above 1.25, meaning the company generates sufficient profit to cover its debt obligations with a cushion. This ensures that even if there is a drop in income, the company can still meet its debt payments.
A bad DSCR is below 1, indicating that the company is not generating enough income to cover its debt, putting it at risk of default. Lenders view a high DSCR as a sign of financial stability, while a low DSCR raises red flags about the company’s ability to manage its debts and generate profit. Entrepreneurs working on their entrepreneurship journey must consider DSCR for managing their long-term financial health.
How to improve DSCR
To maximise your loan eligibility, it is important to focus on improving your Debt Service Coverage Ratio (DSCR). Here are several effective strategies:
Carefully review historical operating expenses to identify non-recurring or unusual expenditures. For instance, capital expenses mistakenly categorised as repairs or unusually high expenses in legal, insurance, or maintenance due to unique events can be adjusted to reflect a more typical financial scenario. Additionally, interest rates significantly impact DSCR; taking advantage of lower interest rates reduces debt obligations, improving your DSCR.
Selecting longer loan amortisation periods can reduce your monthly debt payments, thus improving your DSCR. Borrowers seeking to refinance with favourable long-term rates and extended repayment schedules can consider financing programs like HUD/FHA 223(f). This program offers competitive Loan-to-Value (LTV) ratios and minimum DSCR requirements, as outlined below:
- Market Rate Properties: Maximum LTV of 85% and a minimum DSCR of 1.18
- Affordable Properties: Maximum LTV of 87% and a minimum DSCR of 1.15
- Subsidised Properties: Maximum LTV of 90% and a minimum DSCR of 1.11
Interest coverage ratio vs. DSCR
| Feature | DSCR (Debt Service Coverage Ratio) | Interest Coverage Ratio (ICR) |
| What it measures | Covers all debt obligations, including principal and interest | Covers interest payments only |
| Purpose | Checks overall ability to repay total debt | Checks ability to meet interest payments |
| How it is calculated | Net Operating Income ÷ Total Debt Payments | EBIT ÷ Interest Expense |
| Best used for | Assessing long-term financial strength and suitability for loans | Assessing short-term capacity to handle interest costs |
Advantages and disadvantages of DSCR
| Advantages | Disadvantages |
| Helps assess a company’s debt repayment ability | Can be misleading if income is inconsistent |
| Crucial for securing business loans | Ignores future changes in expenses or revenue |
| Highlights a company’s financial health | May not reflect short-term liquidity issues |
| Useful for long-term financial planning | Calculation may vary across industries |
How to calculate the DSCR in Excel?
- Open Excel: Set up a spreadsheet with two columns: one for income and one for debt service.
- Input values: Enter the company’s net operating income and total debt service for a specific period.
- Apply the formula: In an empty cell, type = NetOperatingIncome/TotalDebtService and press Enter. The result will be the DSCR.
- Check your data: Ensure that depreciation is not included in the net operating income calculation, as it is a non-cash expense.
- Analyse the ratio: Interpret the result to assess if the company can meet its debt obligations.
Factors influencing DSCR
Several factors affect a company's debt service coverage ratio, including the net operating income (NOI) and total debt service (TDS). Factors influencing the NOI include the company’s operating income, interest rates, debt structure, non-operating income and expenses, and business cycles. Other factors affecting the TDS include operating costs, revenue fluctuations, loan terms, depreciation, amortisation, salaries, capital expenditures, and more.
By understanding the key factors that impact DSCR, companies can improve their financial position and make better borrowing decisions. Lenders may also use this ratio to guide their lending decisions. Knowing these factors gives both borrowers and lenders a clearer view of a company's ability to cover its debt. This allows them to evaluate the company’s overall financial health and long-term viability.
Conclusion
The Debt Service Coverage Ratio (DSCR) is a crucial financial metric that measures a company’s ability to repay its debt. It’s a key indicator used by lenders when assessing eligibility for Bajaj Finserv Business Loan. A higher DSCR represents strong financial health, while a low DSCR can indicate potential risk. Calculating DSCR in Excel simplifies the process, enabling businesses to make informed decisions regarding debt management.
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