There are many different tools used for assessing loan eligibility. One of these tools – the debt service coverage ratio (DSCR) – can help lenders get to the root of the matter: will this business be able to repay the loan in full and on time. Find out everything you need to know about the debt service coverage ratio formula with our comprehensive guide, starting with our debt service coverage ratio definition.
Debt service coverage ratio definition
Put simply, the debt service coverage ratio is a measurement of a company’s ability to use their operating income to repay their short and long-term debt obligations. Along with the debt-to-equity ratio, it’s often used by lenders to analyse whether a business has enough cash flow to pay their debts, while it may also be utilised in leveraged buyouts to explore the debt capacity of the company that’s being bought out.
Debt service coverage ratio formula
Want to know how to do a calculation for the debt service coverage ratio? Here’s a basic debt service coverage ratio formula that you can use:
Debt Service Coverage Ratio = EBITDA / Interest + Principal
So, what do these terms actually mean? EBITDA refers to your company’s Earnings Before Interest, Tax, Depreciation, and Amortization. Essentially, it’s a measurement of the financial health of your core business operations. Principal is the total loan amount of your borrowings, while interest refers to any interest that is payable on your short or long-term debts.
Some businesses choose to use a slightly different debt service coverage ratio formula:
Debt Service Coverage Ratio = EBITDA – Capex / Interest + Principal
The rationale behind this is that Capex (Capital Expenditure) isn’t expensed on your income statement, as it’s considered an investment. Substituting Capex from EBITDA may provide you with a more accurate picture of your company’s operating income.
What is a “good” debt service coverage ratio?
In short, if your calculation for the debt service coverage ratio produces a figure of 1 or more, then your business has enough operating income to cover the debts. While this doesn’t guarantee that your business will be eligible for a loan, it’s generally a prerequisite. A score of less than 1 indicates that the business won’t be able to repay its loan back on time and with interest and is therefore unlikely to be considered for a loan. If your business has a score of exactly 1, it means you have exactly enough cash flow to pay for your expenses, but no more. Again, you’re unlikely to be considered eligible for a loan with a debt service coverage ratio of 1.
Debt service coverage ratio example
Now, let’s take a look at a debt service coverage ratio example to see how this works in practice. Let’s imagine that Company A has short-term debts of £10,000 and long-term debts of £25,000. The interest rate on the short-term debt and long-term debt is 5% and 4%, respectively. Company A’s EBITDA is £79,000. So, using the debt service coverage ratio formula (including Capex), we find:
DSCR = £79,000 / (£10,000 x (1 + 5%)) + (£25,000 x (1 + 4%) = 2.16
How to improve your debt service coverage ratio?
Do you have a poor debt service coverage ratio and want to improve it? There are a number of different things that you can do. First off, you can increase revenues. Consider boosting prices or negotiating higher contracts with your clients. You can also consider reducing your company’s operating expenses. Think about cutting overheads or tightening up your marketing budget.
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