Debt service coverage ratio definition
/What is the Debt Service Coverage Ratio?
The debt service coverage ratio measures whether a business has sufficient cash flow to pay its debt obligations. In essence, it compares cash flows to debt service payments. A positive debt service ratio indicates that an organization’s cash flows can cover all offsetting debt payments, while a negative ratio indicates that the business must contribute additional funds to pay for the annual loan payments. This is only possible if the business has a substantial cash reserve, or access to additional funds from investors. Lenders are unlikely to lend additional funds to a business that exhibits a negative debt service coverage ratio, and may require borrowers to maintain a debt service coverage ratio of greater than 1 over the life of their loans.
A very high debt service coverage ratio gives a business a substantial cushion to pay for unexpected or unplanned expenditures, or if market conditions result in a significant decline in future income.
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How to Calculate the Debt Service Coverage Ratio
To calculate the ratio, you will need a company’s net operating income (essentially its earnings before interest and taxes), as well as its total debt service, which is its scheduled interest, principal, and lease payments for the coming year. The formula is as follows:
Net annual operating income ÷ Total of annual loan payments = Debt service coverage ratio
For more accuracy, reduce the total debt service figure by the beneficial effect of the deductibility of interest payments on income taxes.
It may be necessary to calculate this ratio regularly and track it on a trend line, since the net annual operating income figure may vary substantially over time. The debt service figure may also vary, if the debt is subject to a variable interest rate. These two factors can result in a great degree of variability in the debt service coverage ratio’s results.
Example of the Debt Service Coverage Ratio
A business generates $400,000 of cash flow per year, and its total annual loan payments are $360,000. This yields a debt service ratio of 1.11, meaning that the firm generates 11% more cash than it needs to pay for the annual debt service. The calculation is as follows:
$400,000 Net annual operating income ÷ $360,000 Total of annual loan payments = 1.11 Debt service coverage ratio
Problems with the Debt Service Coverage Ratio
An issue regarding this ratio is that a negative outcome can result when a property is transitioning to new tenants, so that it is generating sufficient cash by the end of the measurement period, but was not doing so during the beginning or middle of the measurement period. This is because the loan payments associated with a fixed-rate mortgage will stay the same over time, while the tenant rent payments will likely go up over time (unless there is a rent control law in effect). Thus, the metric can yield inaccurate results during transition periods.
Interest Coverage Ratio vs. Debt Service Coverage Ratio
The interest coverage ratio shows how many times an organization’s operating profit will pay for just the interest on its debts. This approach varies from the debt service coverage ratio, which also addresses the ability of a company to pay the principal portion of its debts. As such, the debt service coverage ratio is more realistic, except in cases where a business does not have to pay any principal within the next year - in which case the results of the two measures should be the same. In both situations, if the ratios result in a figure of less than 1, then the entity is not generating sufficient income to pay for its ongoing debt obligations, making it a risky borrower for any prospective lender.