Debt service coverage ratio (DSCR) Definition
Debt service coverage ratio (DSCR) is the financial ratio which is used to measure the ability of the company to service its current debt by comparing the net operating income with total debt service obligation of this company.
In simple words, this ratio is used to compare the available cash of the company with the interest, principal and sinking funds of the company.
For the creditor and for investor debt service covering ratio is important but creditor use this ratio most. This ratio measures the ability of the company to create the current obligation debt.
With the knowledge of cash position and cash flow of the company creditor also want to know that how much debt company currently owe and about the cash of the company which used to pay the current and future debt.
Debt service coverage ratio considers all the expenses related to debt like interest expense and other obligation such as pension and sink fund obligation. These expenses with debt do not consider in the debt ratio so ac compare to debt ratio, debt service coverage ratio tell more about the ability of the company to pay its debt.
Debt service coverage ratio formula can be calculated by dividing the operating income by total debt service cost that is
Debt service coverage ratio= operating income/ total debt service cost
After the payment of all operating expenses, income or cash flow left is called the net operating income. This is also called earnings before interest and taxes (EBIT). On the income statement, the net operating statement is separately listed.
All the costs which are related to servicing the debt of the company are called total debt service which includes the interest payment, principal payment, and other obligation. The amount of debt service given in the set of the financial statement.
Debt service coverage ratio uses to measure the ability of the company to maintain the level of current debt. The high ratio of DSCR is favourable as compared to low DSCR. If ratio high then there is more income available to pay the debt.
If the debt service coverage ratio result is 1 it means that net operating profit of the company and debt service obligation of the company are equal. So company revenue is enough to pay off debt service obligation. But if the ratio is less then 1 then the company cannot generate enough revenue to pay of debt obligation of the company.
So the companies which have higher debt service coverage ratio have more cash and able to pay off debt obligation on time.
Bob has a shoe store and wants to remodel the storefront. But bob has not enough cash for remodelling the storefront so he applies for the loan. Bob already get several loans from the bank because of which he worries that his application for the loan is not approved. According to the financial statement, Bob has the following values.
- Net operating profit= $150,000
- Interest expense= $55,000
- Principal payment=$35,000
- Sinking fund obligation=$25,000
From the above values now we calculate the debt service coverage ratio of Bob’s store
1.3= 150,000/(55,000 + 35,000 + 25,000)
Ratio gain by the Bob is comfortable. To pay the current debt service cost he makes enough in operating profit.
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