Debt Coverage Ratio

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What is the Debt Coverage Ratio?

The debt coverage ratio is one of the important solvency ratios and helps the analyst determine if the firm generates sufficient net operating income to service its debt repayment.

Table of contents
  • The debt coverage ratio is a crucial solvency measure that helps analysts determine if a company has sufficient net operating income to fulfill its debt obligations.
  • Two groups are interested in investing in the company. One group wants to lend money but must ensure the company can cover the loan payments. The other group, consisting of internal individuals, uses a formula to assess if external financing is necessary.
  • When making investment decisions, investors consider the company's operating income to debt payment ratio, which is a vital metric for evaluating stability.

Debt Coverage Ratio Formula

Let us look at the debt coverage ratio formula:

debt coverage ratio

By using this formula, we get a clear idea of whether a firm can handle debt payments regularly or not. If the proportion between the net operating income and the debt payment is too low (like one or less), it is better not to go for debt financing. It is better not to loan the amount to that particular company.

The formula is important to two groups of individuals.

  • The first group of people would like to invest in that company. But, before they ever loan the amount to the firm, they want to know whether the firm has enough operating income to cover the payments.
  • The second group of individuals is internal people. They can be from top management or report to the top management. They use this formula to see whether the firm has enough operating income to go for external sources of finance like debt finance.

Also, you may have a look at this detailed post on DSCR

Debt Coverage Ratio Formula in Video

 

Example of Debt Coverage Ratio Formula

Jaymohan Company has been looking for debt financing. They approached nearby banks and financial institutions. Jaymohan Company has found out that the debt service cost would be around $40,000 for a particular period. They want to know whether their net operating income is enough to cover the expenses. You are the accountant of Jaymohan Company, and you found out that the operating income for this particular period is $500,000. Would you think that Jaymohan Company should go for debt financing after all?

The solution lies in debt coverage ratio calculation.

An accountant should see the proportion between the net operating income and the debt service cost.

  • Formula = Net Operating Income / Debt Service Cost
  • = $500,000 / $40,000 = 12.5.

As per the ratio is concerned, Jaymohan Company has enough net operating income to cover the debt service cost for the period.

However, the accountant also needs to see whether similar companies in the same industry have identical or closer results. Or the accountant can also check the industry’s norm to be certain that 12.5 is a good proportion.

Uses

Before the investors decide to loan the company's debt, they look at various metrics.

One of the most important metrics is whether the company has earned enough operating income to cover the debt payment. If not, the investors drop the idea of investing in that company.

This ratio may not be the only formula for the investors to check the company's stability they would like to invest in. Still, it certainly is one of the most important ratios to check whether a firm is worthy or not.

Debt Coverage Ratio Calculator 

You can use the following calculator:

Calculate Debt Coverage Ratio in Excel 

Let us now do the same example above in Excel. It is very simple. You must provide the inputs of net operating income and debt service cost. Then, you can easily calculate the ratio in the template provided.

Debt Coverage Ratio in Excel

You can download this template here - Debt Coverage Ratio Excel Template.

Frequently Asked Questions (FAQs)

1. What is considered a favorable cash debt coverage ratio?

Typically, a cash debt coverage ratio above 1.5 is considered favorable. A ratio above 1.5 indicates that a company's operational cash is 1.5 times greater than its total liabilities, demonstrating its ability to meet its debt obligations with current operating cash comfortably.

2. Is it possible to have a negative debt coverage ratio?

If an organization has a positive debt service ratio, its cash flows are sufficient to cover all debt payments. However, the business must allocate additional funds for annual loan payments if the ratio is negative.

3. What is the significance of the debt coverage ratio?

The debt coverage ratio holds significant importance as it serves as a key indicator of a company's ability to repay loans, secure new financing, and distribute dividends. It is one of three metrics used to assess debt capacity, along with the debt-to-equity ratio and the debt-to-total assets ratio.