Debt Service Coverage Ratio (DSCR): Examples, Formulas, & Examples

Debt service Coverage ratio

The Debt Service Coverage Ratio, abbreviated as DSCR or simply DCR, is a key term in commercial lending and real estate finance. It is essential when underwriting commercial real estate and business loans, as well as tenant financials, and is a significant component in calculating the maximum loan amount. In this article, we’ll go over the debt service coverage ratio in detail and walk through some examples along the way. We’ll also see the two debt service coverage ratio formula and see how to calculate them.

What is Debt Service Coverage Ratio?

The Debt Service Coverage Ratio (DSCR) assesses a company’s capacity to use its operating income to fulfill all of its debt commitments, including principal and interest payments on both short-term and long-term debt. When a corporation has any borrowings on its balance sheet, such as bonds, loans, or lines of credit, this ratio is frequently utilized. It is also a regularly utilized ratio in a leveraged buyout deal, along with other credit indicators such as total debt/EBITDA multiple, net debt/EBITDA multiple, interest coverage ratio, and fixed charge coverage ratio, to analyze the target company’s debt capacity.

Debt Service Coverage Ratio Formula

This debt service coverage ratio formula is in two ways:

Debt Service Coverage Ratio = EBITDA/ (Interest + Principal)

Debt Service Coverage Ratio = (EBITDA – Capex) / (Interest + Principal)

Where:

EBITDA = Earnings Before Interest, Tax, Depreciation, and Amortization.

Principal = The total loan amount of short-term and long-term borrowings.

Interest = The interest payable on any borrowings.

Capex = Capital Expenditure.

Some businesses may prefer to utilize the latter formula because capital expenditure is not expensed on the income statement but is instead regarded as an “investment.” By subtracting CAPEX from EBITDA, the corporation will have the actual amount of operating revenue available for debt service.

How to Calculate Debt Service Coverage Ratio?

This guide will walk you through the process of calculating the Debt Service Coverage Ratio. We’ll go over step-by-step answers to many Debt Service Coverage Ratio Calculations cases.

Example 1 – Income Statement for DSCR

In this example, we will calculate Company A’s Debt Service Coverage Ratio using the following income statement:

AssetMillion
Sales1000
Costs of Goods Sold200
Gross profit800
Operating Expense200
Operating Income600
Interest Expense200
Pre-tax Profit400
Tax Expense200
Net income200
Company A Income Statement

Answer

Step 1: Write the debt service coverage ratio formula down.

DSCR = Debt Service / Net Operating Income

Step 2: Calculate the Net Operating Income.

Operating income is calculated by deducting operating expenses from the firm’s gross profit. In this case, it is $600 million.

Step 3: Locate a Debt Service

Because the entity must pay its interest and principal payments before tax, the debt service is often positioned below the operating income. In this example, debt service is simply the interest expense, which is equal to $200M.

Step 4: Perform the calculation to determine the DSCR.

DSCR = Debt Service / Net Operating Income

DSCR = $600M / $200M = 3 (or 3x because it is a ratio)

Example 2 DSCR Simple Income Statement

In this example, we will calculate Company B’s Debt Service Coverage Ratio using the following data and income statement:

Information:

The principal payments total $150 million.

AssetMillion
Sales1000
Costs of Goods Sold200
Gross profit 800
SG&A Expense300
R&D Expense200
Operating Income300
Interest Expense50
Pre-tax Profit250
Tax Expense50
Net income200
Company B Income Statement

Answer

Step 1: Write the debt service coverage ratio formula down.

DSCR = Debt Service / Net Operating Income

Step 2: Calculate the Net Operating Income.

The operating income comes after the operating expenses (SG&A and R&D expenses). In this case, it is $300 million.

Step 3: Locate a Debt Service

In this case, the debt service is higher because the company must repay the principal as well as interest payments.

Debt service equals the sum of interest and lease payments plus principal repayment.

Debt service = $50 million + $150 million = $200 million

Step 4: Perform the calculation to determine the DSCR.

DSCR = Debt Service / Net Operating Income

DSCR = $300 million / $200 million = 1.5 (or 1.5x)

Example 3 – Elements Missing from Income Statement

In this example, we will calculate Company C’s Debt Service Coverage Ratio using the following data and the income statement:

Information:

R&D Expense accounts for 25% of the firm’s SG&A Expense.

Principal payments and interest expenses each account for 10% of the company’s operating income.

The company’s sales are three times the cost of goods sold.

AssetMillion
Sales?
Costs of Goods Sold?
Gross profit400
SG&A Expense?
R&D Expense200
Operating Income?
Interest Expense?
Pre-tax Profit?
Tax Expense50
Net income?
Company C Income Statement

Answer

Step 1: Write the debt service coverage ratio formula down.

DSCR = Debt Service / Net Operating Income

Step 2: Calculate the Net Operating Income.

To determine the firm’s Net Operating Income, we must first compute the Sales and R&D Expenses (since these values are not provided).

Sales = 3 times the cost of goods sold

3 × $400M Equals $1200M in sales

R&D Expense = 25% of SG&A Expense

R&D Expense = 25% of $200M = $50M

Sales – Cost of Goods Sold – SG&A Expense – R&D Expense = Net Operating Income

Net Operating Income = $1200 million – $400 million – $200 million – $50 million = $550 million

Step 3: Locate a Debt Service

Principal payments and interest expenses each account for 10% of the company’s operating income:

10% x Operating Income = Principal Payments

Principal Payments = 10% x $550 million = $55 million

Interest Expense = 10% of Operating Income

Interest Expense = 10% of $550M = $55M

Locate the Debt Service:

Debt service equals the sum of interest and lease payments plus principal repayment.

Debt service = $55 million + $55 million = $110 million

Step 4: Perform the calculation to determine the DSCR.

DSCR = Debt Service / Net Operating Income

DSCR = $550 million / $110 million = 5 (or 5x)

Example 4 – DSCR + Fill out Income Statement

In this example, we will calculate Company D’s Debt Service Coverage Ratio using the following data and a partial income statement:

Information:

The tax rate is set at 50%.

The firm’s R&D Expense is $10M less than half of its SG&A Expense.

The principal payments are equal to twice the pre-tax profit.

The cost of goods sold is 60% of the sales price.

Net Income equals 25% of Lease Payments.

SG&A expenses account for 30% of the company’s sales.

Lease payments are twice as much as interest payments.

Answer

Step 1: Write the debt service coverage ratio formula down.

DSCR = Debt Service / Net Operating Income

Step 2: Complete the income statement.

Because most line items on the income statement are blank, we must first fill out the income statement using the information we have:

Rent Payments

We can figure out the Lease Payments by starting with the Interest Expense of $20M (the only value we have), which is double the Interest Expense.

Lease payments = 2 x $20 million = $40 million

Profitability

We can now calculate the Net Income (because it is 25 percent of the Lease Payments).

Net income = 25% of $40 million = $10 million

Profit Before Tax & Tax Expense

The 50% tax rate suggests that the tax expense is equal to 50% of the Pre-Tax Profit. The company retains half of its Pre-Tax Profit as Net Income. As a result, we can deduce that the Pre-Tax Profit is twice as large as the Net Income.

Profit before taxes = 2 x $10M = $20M

Pre-Tax Profit – Net Income = Tax Expense

Expenses for taxes = $20M – $10M = $10M

Payments of Principal

Principal payments are equal to double the pre-tax profit.

2 x Pre-Tax Profit = Principal Payments

Principal Payments = 2 x $20 million = $40 million

Operating Profit

Although Operating Income is not shown, we can compute it by adding the line items for which we have values above Pre-Tax Profit.

Operating income is calculated as the sum of pre-tax profit and interest expense.

Operating income = $20 million + $20 million = $40 million

Step 3: Locate a Debt Service

Debt service equals the sum of interest and lease payments plus principal repayment.

Debt service = $20 million + $40 million + $40 million = $100 million

Step 4: Perform the calculation to determine the DSCR.

DSCR = Debt Service / Net Operating Income

DSCR = $40 million / $100 million = 0.4 (or 0.4x)

Debt Service Coverage Ratio Interpretation

A debt service coverage ratio of one or greater implies that a company’s operating income is sufficient to cover its annual debt and interest payments. An optimum ratio is 2 or higher as a general rule of thumb. A high ratio indicates that the corporation is capable of incurring further debt.

A ratio less than one is undesirable since it demonstrates the company’s inability to service its present debt commitments solely through operational income. A DSCR of 0.8, for example, shows that there is just enough operational income to repay 80% of the company’s debt payments.

Rather than focusing on a single metric, analyze a company’s debt service coverage ratio concerning the ratios of other companies in the same industry. If a company’s DSCR is much greater than that of the majority of its competitors, it shows stronger debt management. A financial analyst may also wish to examine a company’s ratio over time to see if it is trending upward (improving) or downward (deteriorating) (getting worse).

Common Applications of the Debt Service Coverage Ratio

The debt service coverage ratio is a standard metric used to assess a company’s capacity to pay its outstanding debt, including principal and interest expense.

In a leveraged buyout, an acquiring business uses DSCR to evaluate the target company’s debt structure and capacity to pay loan obligations.

Bank loan officers utilize DSCR to estimate a company’s debt servicing ability.

Summary

The Debt Service Coverage Ratio is a useful indicator for measuring a company’s overall financial health, specifically its ability to service its present debt. The ratio can also help lenders and investors determine if it is safe for the company to take on more debt funding. The DSCR should always be compared to the industry average.

DSCR Frequently Asked Questions

What is a good debt service coverage ratio for real estate?

Most lenders prefer a DSCR in the 1.25x–1.5x range. This means that, at the very least, the asset can generate an additional 25% of additional income after all debt payments have been made.

How do you calculate debt service coverage ratio in real estate?

Simply divide the net operating income (NOI) by the annual debt to determine the debt service coverage ratio.

Why is debt service coverage ratio important?

The DSCR is a useful benchmark for determining an individual’s or a company’s ability to make debt payments in cash. A higher ratio indicates that the firm is more creditworthy since it has enough finances to service its debt commitments – to make the needed payments on time.

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