What is a Debt Service Coverage Ratio (DSCR)
The debt service coverage ratio (DSCR) is a financial ratio that measures a company’s ability to use its generated cash flow to pay off debt obligations. The DSCR ratio typically uses EBITDA or Net Operating Income to represent cash flow and divides that figure by the sum of loan interest and principal debt payments due in the period. Investors will use this ratio to determine how likely a company is able to pay back its debt obligations.
What is a DSCR Loan
A DSCR loan refers to a loan in which the bank or lending institution uses your company’s debt service coverage ratio to determine the applicable loan terms for the business. A company with a high debt-service coverage ratio is deemed to be low-risk and very likely to be able to pay back its debt obligations which allows the bank to proceed with more generous loan terms (lower interest rates, higher loan amounts, etc.).
DSCR Formula
Most companies will use a combination of cash flow and debt interest and principal payments to calculate their DSCR.
DSCR = Cash Flow / (Interest + Principal)
Formula Inputs:
- Cash Flow: Typically represented by EBITDA (Earnings Before Interest Taxes Depreciation and Amortization).
- Interest: The total interest amount due in the measured period based on the company’s outstanding debt.
- Principal: The total loan principal amount due in the measured period (current portion of long-term debt)
Note: Some adjustments may need to be subtracted from EBITDA to arrive at an accurate cash flow figure depending on other expenses that are paid before any debt obligations (Ex. cash taxes, sales taxes, and other expenses).
Real Estate DSCR Formula
Real estate investors, lenders, and other relevant stakeholders will often use Net Operating Income as a proxy for cash flow when calculating the debt service coverage ratio.
DSCR = Net Operating Income / (Interest + Principal)
- Net Operating Income: Remaining income after accounting for vacancy, management fees, property taxes, improvement reserves, and other operating expenses.
- Interest: The total interest amount due in the measured period based on the company’s outstanding debt.
- Principal: The total loan principal amount due in the measured period (current portion of long-term debt)
Debt Service Coverage Ratio Example
Suppose Candy Co’s income statement reflects $285,000 in earnings before taxes, $50,000 in interest expenses, and $30,000 in depreciation and amortization expenses. We’ll also assume that Candy Co’s balance sheets show the company made principal repayments of $50,000 during the period.
Calculate Candy Co’s debt service coverage ratio:
- EBITDA = $285,000 (earnings before taxes) + $50,000 (interest expense) + $30,000 (depreciation and amortization) = $365,000
- Interest expense + principal payments = $50,000 + $50,000 = $100,000
- DSCR = $365,000 / $100,000 = 3.65
Real Estate Debt Service Coverage Ratio Example
Suppose Brightstar Properties' income statement reflects $30,000 in net operating income. The company also has $5,000 in interest expenses and $12,000 in principal payments due in the period.
Calculate Brightstar Properties’ debt service coverage ratio:
- NOI = $30,000
- Interest expense + principal payments = $5,000 + $12,000 = $17,000
- DSCR = $30,000 / $17,000 = 1.76
DSCR Loan Requirements
Companies that vary by industry, location, size, and other factors will have a different standard for a normal or average DSCR level. Banks and lending institutions will typically require a minimum DSCR ratio and other requirements (debt-to-assets ratio, minimum cash balance, etc.) before allowing a borrower to qualify for a loan.
DSCR Results
- DSCR = 1: When a company’s DSCR is equal to 1 then the company is generating just enough cash flow to cover its exact debt obligations in the period. This ratio of 1 suggests that the company will not have any leftover cash to reinvest into the business or distribute to shareholders after paying its debt obligations.
- DSCR < 1: When a company’s DSCR is less than 1 then the company is not generating enough cash flow to cover its expected debt obligations. This suggests that the company is potentially at risk of bankruptcy if it continues to operate without any changes.
- DSCR > 2: When a company’s DSCR is above 2 then the company is able to cover at least double its debt obligation amount. A high DSCR ratio suggests a healthy cash flow operation and a low debt risk profile.
A company with a DSCR of less than or equal to 1 will unlikely receive any loan or financing offers from a lending institution. A company with a DSCR of at least 1.25 or above may be able to qualify for a DSCR loan.
Interest Coverage Ratio (ICR) vs Debt Service Coverage Ratio (DSCR)
The main difference between the interest coverage ratio and debt service coverage ratio lies in the denominator of the formulas. The interest coverage ratio only divides cash flow by the interest payment amount on a company’s debt while the debt service coverage ratio divides by the sum of both interest and principal debt payments. This makes the debt service coverage ratio more comprehensive in accounting for a company’s full debt obligation.
Debt Service Coverage Ratio Pros and Cons
The DSCR ratio can provide a good starting point for evaluating the financial risk profile of a company. However, a single ratio will likely have other unaddressed considerations or scenarios that might make the ratio misleading or inaccurate. This is why most lending institutions will use a combination of multiple ratios and benchmarks before suggesting any loan terms.
DSCR Pros
- Calculated over a period of time as opposed to a snapshot in time.
- Can be standardized to compare debt obligation risk between different companies.
- Includes both interest and principal payments to cover a company’s full debt obligation.
- Can look at a company’s annual historic DSCR to identify trends in financial health and efficiency.
DSCR Cons
- May require adjustments for certain taxes and other pre-debt expenses.
- Requires adjustments for non-cash expenses (Ex. depreciation and amortization).
- Different lenders have slightly different formula adjustments and preferences making the ratio inconsistent between certain banking or lending institutions.
Additional Resources
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Introduction
Building a cash flow statement from scratch using a company income statement and balance sheet is one of the most fundamental finance exercises commonly used to test interns and full-time professionals at elite level finance firms.
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