Debt Service Coverage Ratio (2024)

Measures a company’s capacity to meet debt obligations using cash generated from operating activities

Over 1.8 million professionals use CFI to learn accounting, financial analysis, modeling and more. Start with a free account to explore 20+ always-free courses and hundreds of finance templates and cheat sheets.

Start Free

Written byCFI Team

The Debt Service Coverage Ratio (sometimes called DSC or DSCR) is a credit metric used to understand how easily a company’s operating cash flow can cover its annual interest and principal obligations.

Because the Debt Service Coverage Ratio also includes principal obligations in the denominator, it’s considered a very useful metric when a corporate borrower has reducing term debt in its capital structure (meaning monthly or annual principal repayments).

Key Highlights

  • DSC is a credit metric that’s widely used to understand a business borrower’s ability to service debt obligations using its operating cash flow.
  • DSC is rarely measured in isolation when analyzing a company; leverage and liquidity are usually assessed concurrently.
  • A higher DSC ratio is better than a lower one, with a typical minimum requirement of 1.25x.
  • Many lenders make adjustments to the DSC formula based on their risk appetite and the nature of a financing request.

Debt Service Coverage Ratio Formula

Conceptually, the idea of DSCR is:

Debt Service Coverage Ratio (1)

Debt Service Coverage is usually calculated using EBITDA as a proxy for cash flow. Adjustments will vary depending on the context of the analysis, but the most common DSCR formula is:

Debt Service Coverage Ratio (2)

Where:

  • EBITDA = Earnings Before Interest, Tax, Depreciation, and Amortization
  • Principal = The total amount of loan principal due within the measurement period (often expressed as the current portion of long-term debt or CPLTD).
  • Interest = The total aggregate amount of interest due within the measurement period, calculated on both the current portions and the non-current portions of long-term debt.
  • Cash Taxes = The proportion of total income tax that’s due in cash during the current measurement period.

How to Calculate Debt Service Coverage Ratio

Let’s look at an example. Assume the client below had $20 million in long-term debt plus $5 million in current portion of long-term debt (CPLTD). Based on that information, plus what’s been provided in the income statement below, what is the borrower’s DSCR?

Debt Service Coverage Ratio (3)

We would plug the numbers into our DSCR formula and calculate as follows:

Debt Service Coverage Ratio (4)

Debt Service Coverage Ratio & Financial Analysis

The Debt Service Coverage Ratio (DSC) is one metric within the “coverage” bucket when analyzing a company. Other coverage ratios include EBIT over Interest (or something similar, often called Times Interest Earned), as well as the Fixed Charge Coverage Ratio (often abbreviated to FCC).

Coverage measures are never taken in isolation when analyzing a company; they’re always used in conjunction with other categories of credit metrics like leverage (Debt-to-Equity, Funded Debt-to-EBITDA, etc.) and liquidity (Current Ratio & Quick Ratio)

DSC is calculated on an annualized basis – meaning cash flow in a period over obligations in the same period. This is in contrast to leverage and liquidity, which represent a snapshot of the borrower’s financial health at a single point in time (usually period end).

In all adjustment scenarios, a higher DSCR is considered better than a lower one. Anything less than 1x (or 1:1) is considered very weak and suggests that a company owes more money to creditors (per year) than it generates in cash per year.

Most commercial banks and equipment finance firms want to see a minimum of 1.25x but strongly prefer something closer to 2x or more. Many small and middle market commercial lenders will set minimum DSC covenants at not less than 1.25x.

Debt Service Coverage Ratio (5)

Debt Service Coverage Ratio – Common Questions

While most analysts acknowledge the importance of assessing a borrower’s ability to meet future debt obligations, they don’t always understand some of the nuances of the DSCR formula.

Common questions include:

Why use EBITDA?

EBITDA is not cash flow. However, it often serves as a proxy for it because it’s easy to calculate, and both its definition and its purposes are generally agreed-upon across jurisdictions.

Some important points include:

  1. Depreciation and amortization are non-cash expenses, so while expensed for accounting purposes, this is cash that’s actually available to service debt and should be added back.
  2. Interest must be added back to the numerator since we’re including it in the denominator (we don’t want to double count it).

Why remove cash taxes?

In most jurisdictions, income taxes owing to the regional or federal governments count as “super-priority” liabilities (meaning they rank above even the senior-most secured creditors).

Basically, the cash portion of taxes owing (meaning any non-deferred portion) must be paid in order for the business to continue operating unimpeded by intervention from tax authorities.

Why not just use cash flow from the cash flow statement?

Cash flow (as expressed on the CF statement) includes increases and decreases of cash like tightening or extending payable days, increasing or decreasing inventory turns, and collecting payments more (or less) quickly from customers.

Because these fluctuate from period to period and are heavily influenced by market forces and supply chain relationships, CF from operations does not always represent a company’s ability to consistently generate earnings and cash flow from its core business operations. This is largely why EBITDA is used.

Other Common DSC Adjustments

Debt Service Coverage formulas and adjustments will vary based on the financial institution that’s calculating the ratio as well as the context of the borrowing request.

Some examples include:

For CAPEX heavy borrowers/industries

Debt Service Coverage Ratio (6)

CAPEX stands for Capital Expenditure. Some businesses require constant reinvestment in order to remain competitive.

Some management teams elect to use cash on hand to support some or all of that CAPEX (meaning it’s not funded by debt, which would be captured in the denominator of the DSC ratio).

In these cases, that’s cash that’s gone and can no longer be used to service debt. Some more conservative lenders will adjust EBITDA accordingly when calculating DSC for CAPEX-heavy industries.

For private, owner-operated businesses

Debt Service Coverage Ratio (7)

Because personal income tax rates can be quite high in many jurisdictions, some owner-operators of small and medium-sized businesses pay themselves a modest management “salary” and instead take compensation through dividends or by moving funds in and out of the shareholder loan accounts.

Adjusting for cash outflows that effectively represent ownership’s compensation gives a more accurate picture of the company’s ability to generate actual profits and cash flows for the purpose of retention in the company (as opposed to funding the owner’s lifestyle).

For specific types of credit requests

Consider a company that’s been renting its warehouse but recently exercised an option to purchase the building. This company’s historical income statements show “rent expense,” but that expense will no longer exist once it owns the building.

Debt Service Coverage Ratio (8)

Assuming the company was looking to take out a Commercial Mortgage to support the property acquisition, the mortgage lender would need to add back rent to the numerator to understand the going-forward cash flow.

Of course, the “new” occupancy cost would be captured in the denominator as the principal and interest obligations for the commercial mortgage loan.

Additional Resources

Thank you for reading CFI’s guide to Debt Service Coverage Ratio. Check out some of our resources below to expand your knowledge and further your career!

  • Debt Default
  • Debt Overhang
  • Operating Cash to Debt Ratio
  • Operating Cash to Total Cash Ratio
  • See all commercial lending resources
Debt Service Coverage Ratio (2024)

FAQs

What is a good debt service coverage ratio? ›

2.0 or Greater. Though there is no industry standard, a DSCR of at least 2 is considered very strong and shows that a company can cover two times its debt. Many lenders will set minimum DSCR requirements between 1.2 and 1.25.

What if DSCR is more than 2? ›

DSCR > 2: When a company's DSCR is above 2 then the company is able to cover at least double its debt obligation amount. A high DSCR ratio suggests a healthy cash flow operation and a low debt risk profile.

What does a DSCR of 1.25 mean? ›

Lenders generally want to see a DSCR of 1.25 or higher — meaning if you have a $1,000 in debt obligation, you'll need $1,250 in net operating income to qualify for a loan.

Can debt service coverage ratio be more than interest service coverage ratio justify your answer? ›

DSCR is a more comprehensive ratio than Interest Coverage ratio as DSCR takes into account the income of the entity than only profit that Interest Coverage ratio does. DSCR covers the debt, while ICR covers how the interest is serviced.

What is a reasonable debt ratio? ›

If your debt ratio does not exceed 30%, the banks will find it excellent. Your ratio shows that if you manage your daily expenses well, you should be able to pay off your debts without worry or penalty. A debt ratio between 30% and 36% is also considered good.

What is too high for debt service ratio? ›

Debt and Debt Ratios

The Total Debt Service Ratio is the percentage of your income that's needed to cover all of your monthly debt payments. Where the ratio exceeds forty (40) percent of your total monthly income, you could be carrying too much debt and are at risk of bankruptcy or financial insolvency.

Is a DSCR of 3 good? ›

A DSCR that's less than 1 means the company isn't bringing in enough money to pay its debts. A company that has a DSCR of 0.75, for example, would only generate enough money to pay its debt for nine months of the year; a company reporting a DSCR of 3 would be making enough to pay its debts for three years.

What's the lowest can get on DSCR? ›

Many lenders will require a 1.25 DSCR to qualify for a DSCR mortgage loan. However, Griffin Funding allows real estate investors to qualify for a loan with a DSCR of less than . 75. Please note that borrowers with a good DSCR ratio can secure more beneficial rates and terms on their loans with fewer requirements.

What is the minimum DSCR value required? ›

While a DSCR of 1.25 is the minimum requirement for most lenders, a higher number — such as 2 — shows lenders you are financially stable and can repay your debts. A higher DSCR can also mean a potentially lower interest rate as lenders see you as less of a risk for defaulting on your business loan.

What does a DSCR of 0.5 mean? ›

Conversely, a ratio below 1 is not a good sign because it means that the company is unable to service its current debt commitments. For example, if a company has a DSCR of 0.5, then it is able to cover only 50% of its total debt commitments.

What is 1.15 debt service coverage? ›

The minimum DSCR can be different for other types of lenders. For example, the U.S. Small Business Administration (SBA) looks for a DSCR of at least 1.15 to approve a loan. While lower, this score still indicates that you're able to run your business effectively while you repay the loan.

Is a 1.5 DSCR good? ›

The DSCR metric compares a property's income with its debt obligations. Properties with a DSCR of more than 1 are considered profitable, while those with a DSCR of less than 1 are losing money. Most lenders prefer to see DSCRs of at least 1.20x.

What is the most common debt coverage ratio? ›

Generally, lenders frown on a negative cash flow, but some allow it if the borrower has strong outside income. Typically, most commercial banks require the ratio of 1.15–1.35 × ( NOI / annual debt service) to ensure cash flow sufficient to cover loan payments is available on an ongoing basis.

Is a higher debt coverage ratio better? ›

In all adjustment scenarios, a higher DSCR is considered better than a lower one.

What does debt service ratio implies ratio between? ›

In economics and government finance, a country's debt service ratio is the ratio of its debt service payments (principal + interest) to its export earnings. A country's international finances are healthier when this ratio is low. For most countries the ratio is between 0 and 20%.

What is a 1.5 debt service coverage ratio? ›

For example, a property with a debt coverage ratio of 1.5 generates enough income to pay all of the annual debt expenses, all of the operating expenses and actually generates fifty percent more income than is required to pay these bills.

What is a 1.15 debt service coverage ratio? ›

The minimum DSCR can be different for other types of lenders. For example, the U.S. Small Business Administration (SBA) looks for a DSCR of at least 1.15 to approve a loan. While lower, this score still indicates that you're able to run your business effectively while you repay the loan.

What is a 1.2 debt service coverage ratio? ›

If the DSCR is 1.2, that means the property can cover its total debt 1.2 times over the current year. This is assuming that the debt obligations do not increase. Naturally, a DSCR of less than 1 is not as reassuring for lenders.

References

Top Articles
Latest Posts
Recommended Articles
Article information

Author: Sen. Ignacio Ratke

Last Updated:

Views: 6097

Rating: 4.6 / 5 (76 voted)

Reviews: 83% of readers found this page helpful

Author information

Name: Sen. Ignacio Ratke

Birthday: 1999-05-27

Address: Apt. 171 8116 Bailey Via, Roberthaven, GA 58289

Phone: +2585395768220

Job: Lead Liaison

Hobby: Lockpicking, LARPing, Lego building, Lapidary, Macrame, Book restoration, Bodybuilding

Introduction: My name is Sen. Ignacio Ratke, I am a adventurous, zealous, outstanding, agreeable, precious, excited, gifted person who loves writing and wants to share my knowledge and understanding with you.