Debt service coverage

In general, coverage ratio can be described as included in any of a group of financial ratios that are used in order to calculate the capacity of all the companies to repay their financial obligations. The ratio which is higher points out a major ability of the companies to fulfill their financial obligations. The ratio which is lower marks this ability as a minor one. There are types of coverage ratios that are used most often are the following:

• interest coverage ratio
• debt service coverage ratio
• cash coverage ratio
• asset coverage ratio.

In the sphere of finances, the debt-service coverage ratio (also known as the abbreviation DSCR) or the debt coverage ratio (DCR) can be defined as a measurement of the cash income in order to be available to pay current debt obligations. DSCR is the ratio of money which is achievable to be spent on debt servicing, such as:

• interest
• lease payments
• principal payments.

The ratio states net operating income as a multiple of debt obligations due within one year, including interest, principal, sinking-fund and lease payments.

Debt service coverage in various spheres

DCR is a measurement that is used by bank loan officers to decide income property loans. It is the measurement of any entity, that means a person or a corporation, and their capacity to produce enough money in order to cover the debt payments. The rule is that the higher the ratio is, the easier it is for a person or a corporation to be granted a loan.

In corporate finance world DSCR is ratio of the money flow which allows to pay actual debt obligations. The measurement defines net operating income as a multiplicity of debt obligations during a year, that includes principal, interest, lease payments and sinking-fund. DSCR or DCR can also be used in commercial banking. It may be defined as a minimum measurement which a lender can accept. In some cases and circumstances, the breach of DCR covenant can be perceived as an act of default.

When it comes to authority section Debt Service Coverage Ratio is the ratio of export incomes which are needed to pay annual interest and principal payments on the external debts of a country. In all the cases, the measurement presents the capacity to service debt given a particular level of income.

Calculating the Debt Service Coverage Ratio

In general, the DSCR can be calculated with the use of following structure :

${\text{Debt Service Coverage Ratio}}={{\text{Net Operating Income}} \over {\text{Total Debt Service}}}$

This means that net operating income (which is revenue minus certain operating expenses) are divided by total debt service, id est current debt obligations. What is more, total debt service relates to actual debt obligations, this means principal, interest, principal, and lease payments which have to be paid in the next year. This will include both short-term debt as well as long-term debt in a specific and current portions. It is very often investigated as the counterparts of the company's earnings before interest and tax (also known as EBIT).

Examples of Debt service coverage

• Debt service coverage ratio (DSCR): This is a ratio that measures the cash flow available to service the company’s debt obligations. It is calculated by dividing the company’s operating income by its total debt payments. A higher ratio indicates that the company is more likely to be able to meet its debt payments.
• Interest coverage ratio (ICR): This is a ratio that measures the ability of a company to meet its interest payments. It is calculated by dividing the company’s operating income by its total interest payments. A higher ratio indicates that the company is more likely to be able to meet its interest payments.
• Fixed charge coverage ratio (FCCR): This is a ratio that measures the company’s ability to meet its fixed charges such as rent and insurance. It is calculated by dividing the company’s operating income by its total fixed charges. A higher ratio indicates that the company is more likely to be able to meet its fixed charges.
• Cash flow coverage ratio (CFCR): This is a ratio that measures the company’s ability to meet its cash flow obligations. It is calculated by dividing the company’s cash flow from operations by its total debt payments. A higher ratio indicates that the company is more likely to be able to meet its cash flow obligations.

Advantages of Debt service coverage

A coverage ratio is a useful tool for analyzing a company's ability to pay its financial obligations. The debt service coverage ratio is one of the most commonly used coverage ratios and it measures a company's ability to generate enough cash flow to cover its debt payments. The advantages of debt service coverage ratio include:

• It provides an indication of a company's ability to pay off its debt obligations. It is also a useful indicator of a company's financial health and stability.
• It is a quick and easy way to compare a company's financial performance over time and against other companies in the same industry.
• It helps lenders to assess a company's ability to manage its debt and is an important factor in loan approval decisions.
• It provides a benchmark for companies to measure their own performance and to compare their performance to industry peers.

Limitations of Debt service coverage

The most commonly used coverage ratios are the following:

• Debt Service Coverage Ratio (DSCR): This ratio measures a company's ability to cover its debt payments with its net operating income. However, it does not take into account any additional sources of income or expenses that may impact the company's ability to pay its debt obligations.
• Interest Coverage Ratio (ICR): This ratio measures the capacity of a company to pay its interest payments with its net operating income. It does not consider any additional sources of income or expenses that may affect the company's ability to meet its debt obligations.
• Cash Flow Coverage Ratio (CFCR): This ratio measures the ability of a company to generate enough cash flow to service its debt obligations. It does not take into account any additional sources of income or expenses that may impact the company's ability to pay its debt obligations.
• Leverage Ratio: This ratio measures the amount of debt a company has relative to its equity. It does not consider the company's ability to generate enough income to cover its debt obligations.
• Asset Coverage Ratio: This ratio measures the amount of a company's assets that are available to cover its debt obligations. It does not consider any additional sources of income or expenses that may impact the company's ability to pay its debt obligations.

Other approaches related to Debt service coverage

In general, coverage ratio can be described as included in any of a group of financial ratios that are used in order to calculate the capacity of all the companies to repay their financial obligations. The ratio which is higher points out a major ability of the companies to fulfill their financial obligations. The ratio which is lower marks this ability as a minor one. Other approaches related to debt service coverage include:

• Interest Coverage Ratio - which measures the ability of a company to pay its interest expenses on its outstanding debt.
• Debt to Equity Ratio - which measures the ratio of total debt to total equity in a company's balance sheet.
• Cash Flow to Debt Ratio - which measures the ability of a company to cover its debt payments from cash flows generated from its operations.

In summary, the coverage ratio is a financial ratio used to measure the capacity of a company to repay its financial obligations. Other approaches related to debt service coverage include the Interest Coverage Ratio, Debt to Equity Ratio, and Cash Flow to Debt Ratio.

Footnotes

Debt service coverage — recommended articles

Debt to total assets ratio — Fixed-Charge Coverage Ratio — Solvency ratios — Ebitda ratio — Capitalization ratio — Payables turnover — Cash Flow-to-Debt Ratio — Acid-test ratio — Asset coverage ratio

References

• Andrukonis D., (2013), Pitfalls on Conventional Earnings - Based DSCR Measures and a Recommended Alternative in The RMA Journal, May 2013
• Bragg M. S., (2012), Business Ratios and Formulas John Wiley & Sons, Inc., New Jersey
• Gibson H. C., (2013), Financial Reporting & Analysis South - Western, Cengage Learning, USA
• Hayes A., (2019), Debt-Service Coverage Ratio - DSCR Definition

Author: Jakub Chmiel