Debt-Service Coverage Ratio (DSCR)

What is DSCR?

The debt-service coverage ratio (DSCR) measures a company’s ability to cover its debt payments from operating income. Lenders, investors, and managers use DSCR to assess whether a business generates sufficient cash flow to meet principal and interest obligations.

A DSCR of:
– 1.00 means operating income exactly covers debt service.
– < 1.00 means operating income is insufficient to meet debt payments.
– ≥ 1.25 is commonly considered a strong buffer; some lenders require at least 1.2–1.25.
– ≥ 2.00 is typically viewed as very strong.

Formula and definitions

DSCR = Net Operating Income / Total Debt Service

Where:
– Net Operating Income (NOI) = Revenue − Operating Expenses (excluding interest and taxes). NOI often aligns with EBIT.
– Total Debt Service (TDS) = principal + interest (and other required debt-related cash outflows such as sinking funds and certain lease payments) due during the period.

To account for tax-deductible interest:
TDS ≈ (Interest × (1 − Tax Rate)) + Principal

How to calculate (step-by-step)

1. Determine the measurement period (usually trailing 12 months or the fiscal year).
2. Calculate NOI (exclude interest and taxes).
3. Sum required debt payments for the same period (principal, interest, sinking funds, lease payments).
4. Apply DSCR formula.

Example:
– NOI = $100,000
– Total debt service = $60,000
– DSCR = $100,000 / $60,000 = 1.67

Real-estate example:
– NOI = $2,150,000
– Debt service = $350,000
– DSCR = $2,150,000 / $350,000 = 6.14

Lender considerations and loan covenants

• Lenders commonly set minimum DSCR covenants (e.g., 1.2–1.25). Falling below a covenant can trigger remedies or penalties.
• A DSCR near 1.00 is risky: small income declines can make debt unserviceable.
• Higher DSCR generally yields more favorable loan terms (higher loan amounts, lower rates, better LTV).
• Loan agreements may specify actions if DSCR falls below triggers (e.g., diverted revenues, additional collateral).

DSCR vs. Interest Coverage Ratio

• Interest Coverage Ratio = EBIT / Interest Expense. It measures the ability to pay interest only.
• DSCR includes both principal and interest, so it gives a fuller view of cash required to service debt.
• Use interest coverage to assess interest burden; use DSCR to assess overall debt service capacity.

Advantages

• Tracks cash-flow capacity over time (monthly or rolling 12 months).
• Useful for comparisons across companies and industry peers.
• More comprehensive than interest-only metrics because it includes principal repayments.
• Helps lenders and management monitor credit risk and plan financing.

Limitations

• Calculations vary by lender (NOI vs. EBIT vs. EBITDA), reducing comparability.
• Excludes certain expenses (e.g., taxes, non-cash charges) depending on the version used.
• Relies on accounting figures that may not match actual cash timing (accrual vs. cash basis).
• No universal standard—industry, size, and lender expectations influence what’s “good.”

Quick FAQs

• What is a good DSCR? Generally, above 1.25 is considered strong; lenders often require at least 1.2–1.25. Below 1.0 indicates inability to meet debt service from operations.
• How often should DSCR be measured? Commonly monthly, quarterly, or as a rolling 12-month figure for trends and covenant compliance.
• Can DSCR be improved? Yes—by increasing operating income, refinancing to lower payments, extending maturities, or reducing operating costs.

Takeaway

DSCR is a practical, widely used ratio that compares operating income to required debt payments. It helps lenders and companies evaluate credit capacity and financial resilience, but interpretation requires attention to how NOI and debt service are defined and to industry norms.