DSCR (Debt Service Coverage Ratio)

Debt Service Coverage Ratio (DSCR) calculates the ability of companies to manage their current debt obligations using the available resources. The computation of this ratio allows stakeholders to assess the company's financial state and check if it is capable enough to repay its outstanding long-term and short-term dues.

When the DSCR ratio is known, it becomes easier for lending institutions to decide whether to approve a company’s loan application, given their current availability of resources. The higher the ratio, the higher the firms' chances of obtaining credits or loans. 

• The debt service coverage ratio (DSCR) is the ratio that helps assess the ability of a company to repay its debts.
• It is derived by dividing the net operating income by the total debt service.
• If this ratio is less than one, it means that the net operating income generated by the company is not enough to cover all the debt-related obligations of the company.
• A bank, however, does not consider the DSCR alone to approve the loan. Instead, it looks into the company's way of managing financial obligations in the past. 

DSCR is yet another tool to check the capacity of businesses to pay back their loan. The other two metrics include the debt-to-equity ratio and the debt-to-total assets ratio. In short, ideal debt service coverage ratio is an indicator of an organization's financial health.

It is derived when the net operating income is divided by debt service. The net operating income is the earnings before interest and tax (EBIT). As the name suggests, it is the amount from which the interest and tax payments have not yet been deducted. However, in this case, the net operating income is the earnings before interest, tax, depreciation, and amortization (EBITDA).

The next factor in determining the ratio is the total debt service, which includes all housing and non-housing obligations of a borrower. This helps lenders derive the debt service coverage ratio for real estate or other loans to understand how capable the finance seeker is of paying them back on time.

A good debt service coverage ratio is calculated using the following formula:

DSCR= Net Operating Income / Debt Service

Where,

• Net Operating Income = Total Revenue – All Operating Expenses
• Total Debt Service = Interest + Principal Repayments + Lease Payments

If the standard debt service coverage ratio calculated for a company is one or more, it can manage the financial obligations from the revenue generated. When the figure equals 1, the organization earns precisely what it needs to repay its outstanding loans. Hence, having one as the DSCR does not allow bearing any additional costs or obligations. As a result, loan approval could be doubtful.

On the other hand, if the same is more than 1, the banks will happily approve loans as they know they will surely get back the lent amount and interest from borrowers. Thus, a DSCR of more than 1 is considered an ideal debt service coverage ratio.

Example 1

Suppose an investor wants to consider the DSCR of a company before saying yes to investing in it. Here are the details that would be required:

• Revenue =$510 m,
• All Operating Costs = $200 m
• Interest Expense =$60 m,
• Principal Repayments = $35 m.

A. Net Operating Income

Net Operating Income = Revenue – All Operating costs

                                      = $ (510-200) m

                                      = $310 m

B. Total Debt Service

Total Debt Service = Interest + Principal

                               = $ (60+35) m

                               = $95 m

C. Let us calculate the ratio using DSCR formula

DSCR=  Net Operating Income / Total Debt Service

         = 310 / 95

         = 3.26

Example 2 (Using Excel)

Let us analyze the debt situation of the offshore drilling services provider, Seadrill Ltd. In 2016, it faced huge problems due to the piling debt and dwindling margins due to persistently low oil prices. As a result, the company reported the following financial numbers in the three quarters mentioned in the table below:

Here, the ratio’s denominator will not be the total debt service but the minimum debt service requirement, i.e., the minimum pre-tax amount required to fulfill all the debt obligations (pre-tax plus post-tax).

Since the post-tax obligations are greater than the non-cash expenses, the formula used to calculate the minimum debt service required is written in the Description column in the table below. The formula used is .

The standard debt service coverage ratio divides the EBITDA by the value of the minimum debt service requirement. The value of DSCR is much-much less than 1.0. It is expected, given the type of industry Seadrill operates in.

The DSCR drop (31.8 % to 17.0 %) from the second quarter of 2015 to the second quarter of 2016 is drastic. Moreover, it is even steeper (29.4 % to 17.0 %) over the last two sequential quarters (Q1 2016 to Q2 2016). This drastic decline in DSCR is giving a very tough time to Seadrill these days.

The relevance of good debt service coverage ratio is mostly observed when the borrowers' financial strength needs to be assessed. The most common usage is when lenders need to analyze the debt position. Here, the ratio gives a measure of a company's financial condition with respect to its ability to handle existing debt.

The next wide usage of these ratios is in the banks while they sanction loans. Whenever the lenders have to figure out whether to lend money to companies, it looks at the acceptable debt service coverage ratio but they do not base their decision only on that one factor.

It rather observes the normal trend of the industry and then decides whether to approve a loan for the company. In addition, the bank also considers the historical trend of how the company has been managing its debt obligations to assess its future aspects. If the banking institution finds the company worthy, it agrees to current lending and promises to lend more in the future.

DSCR calculates the entity’s ability to meet current obligations but interest coverage ratio calculates the entity’s ability to pay the interest on debt.

An acceptable debt service coverage ratio considers the entire debt, which includes principal and interest, whereas the interest coverage ratio considers only the interest part of the loan.

Suppose the company’s loan is such that only the interest must be paid. In that case, the interest coverage ratio is better than DSCR because calculating the DSCR is useless in such instances.

This is a guide to what is DSCR (Debt Service Coverage Ratio). We explain its formula with example, difference with interest coverage ratio & analysis. You can learn more from the following articles -

• Ratio Analysis
• Types of Financial Ratios
• Financial Ratios