The debt service coverage ratio (DSCR) is the ability of an entity to repay its debt obligations using net operating cash flows.
A positive DSCR means an entity has more cash flows than its current debt obligations, while a negative figure means the inability to service its debts.
What is Debt Service Coverage Ratio (DSCR)?
The debt service coverage ratio is a credit metric that measures the ability of an entity to service its debt with its cash flows.
It assesses the credit risk of a firm in terms of available cash and current loan obligations. Therefore, it links the current portion of long-term debts and short-term obligations with the current cash flows.
Lenders, governments, shareholders, and investors alike can use the DSCR to determine the credit risk of an entity. It shows the ability of a firm to repay its debt obligations on time without relying on external financing.
A positive debt service coverage ratio of above 1.0 indicates that an entity holds sufficient cash to pay its debt obligations. Conversely, a negative DSCR or below 1.0 indicates insufficient cash to meet debt obligations.
How to Calculate the Debt Service Coverage Ratio?
You’ll need a few key components to calculate the DSCR. First, let’s look at the formula.
DSCR = (EBITDA – Cash Taxes)/(Interest + Principal + Leases)
You’ll need the net operating income of an entity first. You can use the gross income figure and adjust it for operating expenses or take the EBITDA amount directly from the income statement.
The debt servicing portion includes the current portion of long-term debt, the current principal amount of loans, capital leases, and interest payable for the current period.
You should take these figures for the same accounting period to avoid confusion. The principal amount of all loans can be calculated separately by analyzing each debt agreement.
Different entities in different industries can make some adjustments to the net cash flows as well as the debt servicing portion.
For example, entities with heavy borrowings need to reinvest money through capital expenditures consistently. Therefore, they can adjust the formula for CAPEX as:
DSCR = (EBITDA – Cash Taxes – Unfunded CAPEX)/(Interest + Principal + Leases)
Similarly, small entities or privately-held companies can deduct shareholders’ withdrawals from the EBITDA amount.
DSCR = (EBITDA – Cash Taxes – Shareholders’ Distribution)/(Interest + Principal + Leases)
Suppose a company, ABC, has an EBITDA figure of $ 2,850,000. Its total interest payments for the period are $ 270,000, and cash taxes payable are $ 180,000.
Let’s assume that the company ABC has a total long-term debt of $ 50 million. The current portion of this long-term debt is $ 2 million.
We can now use the DSCR formula.
DSCR = EBITDA – Cash Taxes / Interest + Principal + Leases
DSCR = 2,850,000 – 180,000/ 270,000 + 2,000,000
DSCR = 1.17
How to Interpret a DSCR?
A debt-servicing coverage ratio of above 1.0 means an entity has more cash reserves than its current debt obligations.
Therefore, a higher DSCR is desired and a minimum of 1.0 is essential. Similarly, a DSCR of below 1.0 means an entity has more debt obligations than its current cash flows.
The DSCR may vary for every entity depending on several factors. For instance, some industries, like retail produce more cash than other industries, like services.
Therefore, the interpretation must include these broader factors as well. Also, like any other financial ratio, the DSCR should not be considered in isolation.
A better analysis of the DSCR is to establish a trend and analyze the debt servicing abilities of an entity rather than looking at a standalone figure.
How DSCR is Used in Financial Analysis?
The most significant use of the DSCR is by lenders. They use this ratio to assess the ability of a borrower to repay debt.
Although lenders and creditors will use other credit and liquidity measurement ratios like the interest coverage ratio, liquidity coverage ratio, quick ratio, etc. as well.
Shareholders and investors can use the DSCR to analyze the potential investment options as well. Most companies can pay consistent dividends if they have adequate resources to service their debts and spare cash reserves.
Similarly, the DSCR can be used as a strategic planning tool to forecast the growth scenarios of an entity based on debt financing.
Important Considerations with the DSCR
As mentioned above, the debt service coverage ratio can vary by industry or by the size of an entity. Then, there are a few other factors to consider when analyzing the DSCR of an entity.
EBITDA or EBIT
You can use either figure from the income statement of an entity. The aim is to use the net operating income of an entity.
The EBITDA adjusts for non-cash flow items like depreciation and amortization. Also, since we don’t exclude interest here, we add it back in the numerator too.
Taxes are considered a preferred obligation for compliance purposes. It means cash taxes are paid before paying any debt obligations (at least theoretically).
Capital leases are also long-term obligations of an entity. Many analysts consider capital leases as a significant portion of the debt obligations of an entity.
Net Cashflows or EBITDA
The purpose of using EBITDA is to assess the ability of an entity to repay its debt obligations. The net cashflows can fluctuate and may not represent the actual earnings of an entity.
Therefore, using the EBITDA figure provides a better measure of the credit risk of an entity.
How to Improve the DSCR?
The first approach to improve the DSCR of an entity is to improve its net operating cash flows. In turn, it can be achieved by improving sales.
Then, you can take measures to reduce the cost of goods sold (COGS) and operating expenses. As the operating efficiency improves, it enhances the DSCR.
Similarly, reducing borrowings can help improve the DSCR. if an entity has a lower proportion of debt and interest in its liabilities section, its DSCR will improve considerably.
However, the aim is to balance the needs of an entity and manage the debt servicing abilities rather than merely improving ratios.
Interest Coverage Ratio vs Debt Service Coverage Ratio
The interest coverage ratio is the measure of an entity’s ability to pay interest payments from its operating income.
It is calculated by dividing the net operating income (EBIT) by its interest payments on all debts. It does not include the portion of principal repayments.
The DSCR includes the interest and the principal portions of the debts of an entity. Although both metrics essentially measure the ability of an entity to repay debt, the DSCR provides a comprehensive metric.
The DSCR covers the current period (which can be monthly, quarterly, or annual). Whereas, the interest coverage is usually calculated by taking annual figures.
What are the Advantages of Using the DSCR?
The debt service coverage ratio can be used by internal and external stakeholders of an entity alike.
It can be used to assess the credit risk of an entity by managers and lenders. It can also be used for potential growth forecasts and strategic planning purposes.
When analyzed over a defined period, it can be used as a quick overview analysis for credit risk assessments. Similarly, when used as an established trend, it can provide a better and more comprehensive analysis of an entity’s financial stability.
Since it uses the EBITDA figure, it can give you an idea about the operational efficiency of an entity as well. Moreover, it analyzes both the interest and principal repayments for a borrower.
What are the Disadvantages of Using the DSCR?
The biggest drawback of the DSCR is its non-uniformity. Analysts can use various versions of the same formula to adjust results to their advantage.
Like other financial ratios, the DSCR can also be manipulated by accounting through window-dressing and short-term adjustments.
The DSCR requires a series of observations over a longer period before a concrete view can be established about the credit risks of an entity.
Also, the EBITDA figure may exclude certain expenses or one-time adjustments like a large lease payment.