Debt Service Ratio
The capacity of a firm to meet all of its debt commitments, including the repayment of principal and interest on both short-term and long-term debt, is what the Debt Service Coverage Ratio (DSCR) evaluates. DSCR is measured as a percentage of the company’s operational income. When a company’s balance sheet contains any kind of borrowing, such as bonds, loans, or lines of credit, this ratio is often calculated and applied. Along with other credit indicators such as the total debt/EBITDA multiple, the net debt/EBITDA multiple, the interest coverage ratio, and the fixed charge coverage ratio, it is also a frequent ratio to employ in a leveraged buyout transaction to analyse the debt capacity of the target firm.
Debt Service coverage Ratio = EBITDA / (interest + Principle)
Debt Service coverage Ratio = (EBITDA-Capex) / (interest + Principle)
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 companies might prefer to use the latter formula because capital expenditure is not expensed on the income statement but rather considered as an “investment”. Excluding CAPEX from EBITDA will give the company the actual amount of operating income available for debt repayment.
Interpretation of the Debt Service Coverage Ratio
A debt service coverage ratio of 1 or higher shows that a firm is producing adequate operational income to cover its yearly debt and interest payments. A debt service coverage ratio of less than 1 indicates that a company is not generating sufficient operating income. A good ratio should be at least two to provide optimal results, as a general rule of thumb. If the ratio is really high, it indicates that the corporation may be able to take on further debt.
A ratio that is lower than one is not ideal since it indicates that the firm is unable to meet its present debt commitments using just its operational revenue. This is not an acceptable situation. For instance, a debt service coverage ratio (DSCR) of 0.8 implies that the firm only has sufficient operational revenue to repay 80% of its debt obligations.
It is more beneficial to analyse a firm’s debt service coverage ratio in relation to the ratios of other companies operating in the same industry as the company in question, as opposed to merely looking at the statistic alone. If a company’s debt service coverage ratio (DSCR) is much greater than that of the majority of its rivals, this is indicative of excellent debt management. A financial analyst may also wish to look at a company’s ratio over time to see if it is going higher (meaning it is becoming better) or downward (meaning it is getting worse) (getting worse).