What Is Debt Service Coverage Ratio, and Why Is it Important?

FT Contributor  | 

Debt service coverage ratio (DSCR), sometimes known as debt coverage ratio, measures the income of an individual investor or business and compares it to their total debt. Lenders look at this ratio when they want to see if a business loan applicant has enough income to pay back the money that they borrow plus interest.

Why is this formula important? The ability to pay one’s debts is a vital aspect of creditworthiness, so the DSCR is one of the primary variables that lenders use when deciding whether or not to approve a loan application. Commercial lenders use the debt coverage ratio formula to assess loan applicants, but equity, real estate, and bond investors also use DCSR data to make decisions about stock or property investments.

The DSCR is primarily for commercial borrowing and investing. When dealing with smaller loan amounts, lenders often prefer to focus on the debt-to-income (DTI) ratio. The DTI is useful to lending institutions for less-complicated transactions such as personal loans and mortgages for home buyers.

What Is the Debt Service Coverage Ratio?

A debt service coverage ratio paints a detailed financial picture by comparing total debt to total assets.

The main components of the debt service coverage ratio are net operating income and total debt. Net operating income is the money left over after an entity covers its operational costs. Meanwhile, the debt figure consists of the principal, interest, and other items such as lease payments and funds for future investment or debt payments (sinking fund payments).

DSCR Formula

The formula looks like this:

DSCR = net operating income (income – operating costs) / total debt payments (principal + interest + other fees and expenses).

When Is DSCR Used?

Who gets their DSCR looked at the most, and under what circumstances?

Analysts can use the ratio to assess the financial health of an entire country, or rather, a national government, which issues bonds and borrows money from lenders. The formula is also vital for corporations and businesses of all sizes. In real estate, mortgage companies compare a property’s net rental income with the overall cost of the loan payments to calculate the debt service coverage ratio.

In some instances, lenders use something called a global debt service coverage ratio to assess a business or individual’s financial situation. This equation is similar to the regular DSCR except for one important difference. The net income or cash flow figure consists of an individual’s personal income as well as revenue from the business or property for which they are obtaining the loan. The global DSCR uses this total combined income to measure the entity’s ability to repay a loan. However, the formula also adds personal debt payments to business debt.

How to Use the Debt Service Coverage Ratio Formula

As a reminder, the debt service coverage ratio formula is as follows:

DSCR = net operating income (income – operating costs) / total debt payments (principal + interest + other fees and expenses).

When measuring the DSCR of a country, creditors and investors compare overall export earnings (income) with total debt obligations from the previous year. For businesses, analysts typically compare yearly cash flow (income) with total annual debt. In real estate, the net operating income is the total income for the year from rent minus taxes, maintenance costs, management fees, and other costs associated with the operation of the property. The debt is the amount of principal plus interest due annually.

What Is a Good DSCR?

Generally, any above one, although the answer can vary depending on who is asking and in what context.

If the answer to a DSCR equation is less than 1, it means that the borrower does not currently have enough income to cover the loan repayment.

Here is an example of a company with a below-par debt service coverage ratio. In this example, a company has a net income of $1 million for the year, and their payments of principal plus interest on loans are $1.2 million.

DSCR = $1,000,000 / $1,200,000 = 0.833 (Bad DSCR).

 

This firm doesn’t have enough to cover their debt payments. Unless there are other circumstances at play, they are not going to get a loan.

In a more-positive example, a property owner earns $1 million per year on a rental property. They pay $200,000 in operating expenses, property taxes, and management fees. That leaves their net income at $800,000. Total principal and interest payments for their property are $500,000 per year.

DSCR = $800,000 / $500,000 = 1.6 (Good DSCR).

This commercial real estate owner can pay their debt and will still have profit left over.

It is clear that DSCR needs to be higher than 1, but how much higher?

That depends on several factors, including the reason for the loan, the history of the borrower, and current economic conditions. If the economy is in good shape, creditors and investors may be willing to overlook a poor DSCR because they expect the borrower’s income to rise in the future.

On the other hand, if the ratio is close to 1, then a minor change in cash flow or downturn in the economy may cause the answer to the DSCR calculation to drop below 1. Lenders like a buffer because it means that the borrower will still be able to pay debts if their cash flow drops. Your loan application is likely to get denied if your DSCR is 1.2 or less. Commercial lenders can require a ratio of 1.35 or higher. The approval threshold could be higher or lower, depending on economic forecasts.

Finally, here is an example of how a global DSCR affects a loan application.

Let’s say the income from your business is $100,000, and your debt is $125,000.

DSCR = $100,000 / $125,000 = 0.8 (Bad DSCR).

Since the DSCR is well below 1, you are not likely to get a loan. However, you have $50,000 of additional income from a job. Your global cash flow is $100,000 + $50,000 = $150,000. Your overall income changes the ratio in your favor.

DSCR = $150,000 / $125,000 = 1.2 (Good Global DSCR).

In other words, your global DSCR is right at the threshold for loan approval. This assumes, of course, that you do not have any additional personal debt.

Getting Help from a DSCR Calculator

DSCR calculation itself is reasonably straightforward. However, the process to arrive at the final figures for this ratio can be somewhat complicated. You have to factor in different numbers depending on the purpose of the loan. Also, you need to figure out how much you pay annually for the loan (plus annual interest payments). You can use an online DSCR calculator to get an accurate picture of the ratio for yourself or your business. These calculators automatically calculate annual payments when you enter the full amount of your loan and interest rate.

The DSCR isn’t the only variable that lenders use to make a decision about a loan, but it is one of the most important figures that they use for their research. You can use the DSCR formula and the online calculators to see where you stand and understand what your chances are of getting a loan for your business or real estate investment.


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This post was updated August 29, 2019. It was originally published September 3, 2019.