Debt Service Coverage Ratio
What is debt service coverage ratio? How to calculate the it? The answers you seek, will be found in this article.
Definition
For a business to expand and prosper, the liquidity and financial boost provided by loans is a necessity. As long as the business entity generates enough cash to pay back interests on loans and cover all of its day-to-day expenses, it can be classified as a sustainable business. The accounting tool which helps quantify the debt repayment ability of an entity, against the debt repayment ability of any business entity.
Simply put, DSCR is obtained by dividing the net income generated by a business entity or individual by the total debt plus interest on loans that a business is liable for. While calculating the income generated by a business, all business running costs and other expenses are subtracted. The debt service costs include principal payment amounts plus interest and in case of real estate business, the lease value is included in the debt servicing. DSCR should not be confused with debt service ratio.
DSCR can be defined in three different ways in context to personal finance, government finance and real estate businesses. In case of personal finance, DSCR is the ratio of an individual's income to the debt servicing amount. In case of a business, it's the ratio of cash flow generated by a business after expenses, to the total debt service payments which includes principal payment.
In case of a real estate business, the DSCR is calculated by dividing the cash flow generated by a property to the lease and mortgage payments that need to be paid for it. If the debt service value is lower than the income of a business entity, then the DSCR is positive and greater than 1. On the other hand, if the DSCR is less than 1, it indicates an overall negative cash flow.
Calculation Procedure
Here's the calculation formula:
Debt Service Coverage Ratio = (Net Operating Income / Debt Service Payments)
To get an accurate DSCR value, you need information about the net operating income of the business after expenses and the total debt service payments. Once you have this value, the DSCR value is just one mathematical calculation away. When calculating the debt repayment ability of a real estate business the debt service payments will also include lease payments, if it's a rental property. Banks require a DSCR ratio greater than 1.3, for a loan application from the business to go through.
Calculator
Here is a simple DSCR calculator, which you may use, to get the DSCR value accurately. Just calculate the net operating income for a financial year after expenses and business management costs and the total annual debt service. Enter them in the calculator below to get the DSCR value directly.
As long as a business can maintain, or a property can maintain a coverage ratio of greater than 1, debt service payments and interests on loans can be paid back to stay afloat. Problems start when the DSCR plunges below 1 and the property of business can't generate enough income to pay back the interest on debts and loans. That's when some drastic decisions need to be taken.
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