DSCR Formula

The DSCR (Debt service coverage ratio) formula provides an intuitive understanding of the debt repayment capacity of the company. It is calculated as the ratio of Net Operating Income to Total Debt Service. In simpler words, the net DSCR formula shows the financial health of the company and the use of its cash flow.

If the ratio is above 1, it indicates that the company has efficient resources and generates sufficient income to meet its debt obligations. Lenders often look at DSCR to assess the risks associated with providing loans. Therefore, a higher number on this metric makes it easier to secure loans for businesses.

The Debt service coverage ratio formula simply takes in net operating income and divides it by the debt service (Interests, sinking funds, tax expense).

It must include all the debt obligation in hand like the following:

• Bank loan
• Short term loans
• Leases
• Monthly payments for debt service

Most lenders use operating income, which is equivalent to EBIT. But some also use EBITDA to calculate the ratio.

Let us understand the formula that shall act as the building block for our understanding of the concept and its intricacies.

Net operating income is calculated as a company’s revenue minus its operating expenses. In most cases, lenders use net operating profit, which is the same as the net operating income. Total debt service is the current debt obligations like loans, sinking funds that need to be paid in the coming year.

The calculation of the net DSCR formula is a simple three-step process which is explain below.

1. Identify Net Operating Income (NOI): Subtract operating expenses from revenue, excluding taxes and interest.
2. Determine Total Debt Service (TDS): Sum all debt-related payments, including principal and interest.
3. Apply the Formula: Use the formula DSCR = NOI / TDS.

Let's see some simple to advanced examples to understand it better.

Example #1

Let’s suppose a real estate developer wants to take a loan from a local bank. Then, the lender will first want to calculate the DSCR to determine the ability of the borrower to repay the loan. The real estate developer discloses that it has an operating income of $200,000 per year and has to pay a yearly interest of $70,000 on the loan he had taken. Therefore, the lender will calculate DSCR to determine whether to grant a loan to the real estate developer.

• DSCR = 200,000 / 70,000
• DSCR = 2.857

A DSCR of 2.857 is a good DSCR for granting a loan to a real estate developer.

Now, if the developer has also lease payments to pay then of $5000, then the debt service will increase to $75000.The new DSCR will be as follows:-

• DSCR= 200,000 / 75,000
• DSCR = 2.66

Therefore the DSCR decreased with an increase in debt service payments.

Example #2

Calculate the DSCR for company X, which has the following Income Statement.

The operating income is calculated by subtracting the expenses from the gross profit.

The debt services will account for the interest expenses and income tax expenses.

Therefore, Operating Income = $13000

Debt Service = $5000

So, the calculation of DSCR will be as follows -

• DSCR =   13000 / 5000

DSCR will be -

• DSCR =   2.6

A DSCR of 2.6 indicates that the company has enough cash to cover its debt obligations.

Example #3

We will calculate the debt service coverage ratio of ILandFS Engineering and Construction Company. We can get the operating profit data, equivalent to operating income and debt service, from the profit & loss statement, which is available in money control.

Source: https://www.moneycontrol.com/

The net operating profit is ₹160.92 in the year 2018.

As for the debt service, we can see that it needs to pay interests that is ₹ 396.03.

Therefore calculation of the DSCR formula will be as follows -

• DSCR = 160.92 / 396.03

DSCR will be

• DSCR =    0.406

A DSCR of 0.406 indicates that the company doesn't have enough cash to cover its debt obligations.

Example #4

We will calculate the debt service coverage ratio of MEP Infrastructure Developers. We can get the operating profit and debt service data from the profit & loss statement, which is available in money control.

Source: https://www.moneycontrol.com/

The net operating profit is ₹218.26 in the year 2018.

As for the debt service, we can see that it needs to pay interests and taxes, which is ₹50.04.

Calculation of DSCR will be as follows -

• DSCR = 218.26 / 50.04

DSCR will be

• DSCR =   4.361

A DSCR of 4.361 indicates that the company has enough cash to cover its debt obligations.

Let us understand the importance of net and gross DSCR formula through the points below.

• DSCR is both important to creditors and investors, but creditors analyze it more as it determines the ability of the lender to repay the current debt.
• The DSCR ratio will determine whether the borrower will get their loan approved and the terms and conditions of the loan.
• It shows that the company is able to manage its financial resources effectively and have a balanced approach to debt.
• It helps creditors assess the risks of lending money to companies.
• It shows that the company is able to clear its debt obligations through revenue generated through its operating income itself.
• A higher DSCR value indicates that the company is better equipped to handle economic downturns. This is an extremely positive sign for investors and stakeholders.

Now that we understand the concept of net DSCR formula in detail, it is also important for us to know how to interpret the numbers that are derived through the application of the formula. Let us do so through the discussion below.

A DSCR ratio of 1 and above is a good ratio. The higher, the better.

• A ratio higher than one indicates that it is generating sufficient cash flow to cover its debt service.
• A ratio less than 1 indicates that there is insufficient cash to cover the debt obligations.

A DSCR of 0.85 indicates that there is only enough operating income to cover 85% of the debt payments.

Most lenders look for a DSCR ratio of 1.15 or more depending on the company's economic conditions.

A lender will never want to make a loss by giving a loan to a borrower who may never be able to repay. The DSCR ratio gives an insight into the company’s cash flow and how much cash the company has to repay its loan.

It is of great importance in real estate or commercial lending, as this ratio gives us an idea of the maximum loan amount a lender can get.

The benefits of a good DSCR are as follows:

• Higher chances of qualifying for a loan
• Better chances to get a lower interest rate.
• Businesses can manage debt obligations in a better way.

Therefore higher the ratio, the better it is.