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
Net operating income: This includes the company’s earnings before interest, taxes, depreciation, and amortisation (EBITDA), providing a clear picture of the business’s income before non-cash deductions.
How to calculate the Debt-Service Coverage Ratio (DSCR)?
To calculate the DSCR, follow these steps:
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 ₹10 lakhs in rental income annually and has ₹6 lakhs in debt service. The DSCR will be calculated as ₹10 lakhs / ₹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 ₹15 lakhs in net operating income and has a debt service of ₹12 lakhs. The DSCR will be ₹15 lakhs / ₹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
The Interest Coverage Ratio (ICR) measures a company’s ability to pay interest on its debt using its revenue, while DSCR includes both interest and principal in the calculation. DSCR provides a more comprehensive view of a company’s ability to cover total debt obligations. ICR only focuses on interest payments, offering insight into short-term debt management. Both ratios are essential for assessing a company’s financial health, but DSCR is more relevant for long-term debt evaluation, while ICR is useful for managing immediate revenue and expenses.
Advantages and disadvantages of DSCR
Advantages
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Disadvantages
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Helps assess a company’s debt repayment ability
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Can be misleading if income is inconsistent
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Crucial for securing business loans
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Ignores future changes in expenses or revenue
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Highlights a company’s financial health
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May not reflect short-term liquidity issues
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Useful for long-term financial planning
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Calculation may vary across industries
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How to calculate the DSCR in Excel?
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.
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.
