Debt Service Coverage Ratio
Debt-Service Coverage Ratio also known as DSCR is a very important ratio in Corporate Finance.
Debt Service Coverage Ratio Definition: -
1. In corporate finance, it is the amount of cash flow available to meet annual interest and principal payments on debt, including sinking fund payments.
2. In government finance, it is the amount of export earnings needed to meet annual interest and principal payments on a country's external debts.
3. In personal finance, it is a ratio used by bank loan officers in determining income property loans. This ratio should ideally be over 1. That would mean the property is generating enough income to pay its debt obligations.
Debt Service Ratio Formula: -
Debt Service Ratio = Net Operating Income Divided by Total Debt Service
The above formula is used to count the DSCR.
Debt Service Ratio Analysis: -
A DSCR of less than 1 would mean a negative cash flow. A DSCR of less than 1, say .95, would mean that there is only enough net operating income to cover 95% of annual debt payments. For example, in the context of personal finance, this would mean that the borrower would have to delve into his or her personal funds every month to keep the project afloat. Generally, lenders frown on a negative cash flow, but some allow it if the borrower has strong outside income.
Debt Service Ratio Calculation: -
Now let us discuss that, How to Calculate Debt Service Ratio? You have to use the above formula to calculate this ratio. Let us understand this by Example.
Debt Service Ratio Example: -
Suppose an investor owns a property with an NOI of $500,000. The annual principal and interest payment for his loan is $370,000. The DSCR would be:
$500,000 = 1.35x
This result means that the property produces a net operating income 35% greater than what is required to pay the loan.
$500,000 - $370,000 = $130,000
$130,000 = 0.35 x 100 = 35%
This additional income can be used by the investor as a return on his equity investment or for additional investment into the property. When a loan has an NOI that is equal to the annual loan payment, it is considered to be at breakeven. This means that the property is operating only enough to cover its loan obligations. When a property has an NOI that is below the annual loan payment, it is considered to be operating below breakeven.
Thus, this is a very important ratio in Financial world.