How the debt service coverage ratio formula delivers a more accurate picture of a company’s financials
There are a variety of accounting strategies that can make a company’s financials look more healthy and stable than they actually are. But when lenders want to know the real picture behind a company’s financial health, they turn to the debt service coverage ratio formula: net operating income/total debt service.
Debt service coverage ratio is a key metric that allows lenders to determine a company’s actual ability to repay a loan—without any of the financial wizardry companies commonly use to make their businesses appear financially sound (even when they’re not).
But what, exactly, is debt service coverage ratio? Why is it so important? And what are the key components to the debt service coverage ratio formula?
What is debt service coverage ratio?
Simply put, debt service coverage ratio formula (often shortened to DSCR) is a metric that measures a company’s cash flow against their debt obligations. Or, in other words, it’s a metric that assesses a company’s available cash to pay off their current debt. DSCR is calculated on an annual basis and compares a company’s annual net operating income (NOI) to the total debt payments the company made during the same 12-month period.
DSCR has value for a variety of business functions, but it’s most often used by lenders to assess a company’s ability to repay a bank loan. It can also be used as a key metric when evaluating a company’s overall value (for example, during a sale or acquisition), and is often used in both commercial real estate and personal finance when underwriting property loans, real estate loans, and mortgages and determining interest rates.
A DSCR of 1.0 is a break-even; it means a company is bringing in exactly the amount of cash flow it needs to repay its current debts. Anything less than a 1.0 means the company is operating with a net loss, while anything above 1.0 means it’s generating more than enough income to cover its debts. Typically, lenders require a debt coverage service ratio of at least 1.2 in order to approve a loan application.
That’s the simple definition of debt service coverage ratio. But when you dig a little deeper, it’s clear why DSCR (and having a debt service coverage ratio formula) is so important.
Why DSCR is important
Debt service coverage ratio formula is such an important metric because it gives a real, accurate picture of a company’s financials—a picture you might not get by looking at the company’s balance sheet or income statement.
When a lender is evaluating whether to approve a loan to a company, they need to know how able that company is to repay that loan according to the lending terms. If a company has too much debt and not enough flow to manage their current debt, a lender likely wouldn’t consider them a desirable candidate for a loan.
But simply looking at a company’s balance sheet isn’t enough for lenders to determine a company’s eligibility for a loan. There are a variety of strategies companies can use to make themselves look more financially stable than they actually are. These discretionary accounting strategies, while legal, are a form of financial engineering specifically designed to paint a rosy picture of their business financials—even if their actual financial picture is anything but rosy. This can be misleading for lenders—and, if they were only to look at a company’s balance sheet, they might grant a loan to a company that’s not in the financial position to repay it.
DSCR takes a stripped down approach to evaluating a company’s financials. It removes all the accounting tricks and tools used by a company to inflate their financials and simplifies the numbers to get a more clear and accurate picture of cash in, cash out, and how able a company is to repay their debts. The debt service coverage ratio gives lenders the information they need to make a sound decision about a company’s financial health—and whether they’re the ideal candidate for a loan.
Clearly, debt service coverage ratio is an important metric to lenders—but it should also be an important metric to business owners. Knowing your DSCR can not only give you a more accurate picture of your company’s financial health (and help you identify potential areas for improvement), but it can also help you determine how likely you are to get approved before you start the loan application process, which can help your organization be better prepared.
A step-by-step guide for mastering the debt service coverage ratio formula
As mentioned, the debt service coverage ratio formula is simple:
Net operating income / Total debt service
But before you can use the formula to determine your DSCR, you need to calculate your NOI and your total debt service.
Step 1: Calculate net operating income
Net operating income is your company’s total revenue minus operating expenses (for example, rent, cost of goods sold, and employee salaries).
Step 2: Calculate total debt service
Total debt service is the sum of all your annual debts, including principal payments, interest payments, and any other debt your business has been carrying.
Step 3: Calculate debt service coverage ratio
Divide your net operating income by your total debt service, an boom! You’ve got your DSCR.
How does interest coverage ratio differ from debt service coverage ratio?
Debt service coverage ratio is a metric used to evaluate a company’s total debt against its net operating income. Interest coverage ratio measures interest payments against a company’s total earnings; it doesn’t factor in principal payments for any debts.
The interest coverage ratio formula is as follows:
Earnings before interest and taxes (EBIT)/ Total interest payments
Similar to DSCR, the higher the interest coverage ratio, the better off the company is financially.
While the interest coverage ratio is a helpful number to know (especially if you’re trying to determine how much of your income is going towards interest payments), it doesn’t offer as comprehensive of a view into a company’s overall financial health as DSCR.
DSCR in action
Now that we’ve unpacked what the debt service ratio formula is, let’s take a look at DSCR in action.
Let’s say you own a company that brings in $250,000 in revenue per year. Your operating expenses are $10,000 per month (for a total of $120,000 per year) and your total debt obligations are another $5,000 per month (for a total of $60,000 per year).
Your net operating income would be your total revenue ($250,000) minus your operating expenses ($120,000)—so your NOI would be $130,000. Then, you would divide that by your total debt service ($60,000), for a DSCR of 2.17. That ratio shows you’re bringing in plenty of cash flow to support your debts—and if your business applied for a loan, chances are lenders would view you as a desirable candidate.
Now, let’s switch things up and say your total operating expenses were $15,000 per month (for a total of $180,000 per year). In that case, your NOI would be $70,000. Divide that by your $60,000 total debt service and your debt coverage service ratio is 1.67—which could make it harder to secure a loan.
Again, DSCR is simple; the higher your revenue and the lower your operating expenses, the higher your debt service coverage ratio will be, the more likely you’ll be to get approved for a loan, and the better off your company will be financially.
Use the debt service coverage formula to assess your company’s financial health
Companies use all sorts of accounting strategies and tricks to make their company appear financially sound. But now that you understand the debt service coverage formula, you can use it to dig into your financials—and make sure that your company doesn’t just appear financially healthy, but actually is financially healthy.
Want to calculate your business’s DSCR? Get started with our Debt Service Coverage Ratio Calculator.