Do you Understand Debt Service Coverage Ratio

Debt service coverage ratio is a ratio commonly used by lenders to assess to the credit worthiness and financial health of a business. It gives a comfort to the lenders if the company generates sufficient cash to pay off its current portion of debt as and when due. Before putting any funds in a business, the lenders also need to be sure that their money would be safe and would indeed be repaid in time. Debt service coverage ratio serves the purpose.

Debt service coverage ratio measures the cash earnings a business is able to generate to pay off its current debt liabilities, both interest and principal repayment. The formula to calculate Debt service coverage ratio is as below:

Debt Service Coverage Ratio = Net Operating Income / Debt Obligations

It is calculated by dividing Net operating income by the debt obligations due. Net operating income is the earnings before interest, depreciation & amortization. The net operating income can be calculated from the income statement by adding interest expense, depreciation and amortization to the profit after tax. Debt obligations refer to the interest payments and principal repayment of debt that is due within an accounting period.

Suppose your business has net operating income of Rs. 50 lakhs and debt obligations of Rs 20 lakhs, the Debt service covergae ratio would be 2.5 (Rs 50 lakhs divided by Rs. 20 lakhs). This means that your business earnings are 2.5 times the current debt servicing liabilities.

The higher the debt service coverage ratio, the easier it is for a business to get loans from lenders. It indicates that the business in generating earnings much higher than what is due and is to be paid to the finance providers. Companies with high debt service ratio are always in a better position to pay off its debt obligations without any default risk. A low debt service coverage ratio results in low credit rating of the business and it would be difficult to obtain funds from the market.

As a borrower, it is important that a company has debt service coverage ratio greater than one. A ratio less than one would indicate that the business is not generating sufficient earnings to pay off its debt obligations and shall result in negative cash flows. The company, then, will have to use its reserves to service its debt liabilities in time.

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