What is Debt Service Coverage Ratio?
Debt service coverage ratio or also called DSCR, is a ratio that is used by almost all commercial lenders. So why is the DSCR one of the most crucial factors lenders use to judge the risk level of your business or investment property loan?
It is such an important factor because lenders use the DSCR to determine whether or not a firm, project, or single borrower, can manage its borrowing costs to an acceptable extent. In other words, a lender uses the DSCR to decide who they should lend their money to or not.
DSCR Formula and how to use it
To get a firm’s DSCR, you need two numbers. The firm’s Net Operating Income or NOI, which is the money a company makes minus any expenses. The second number you need is total debt service or current debt obligations. These obligations are any principal, sinking fund, interest, and lease payments that are due by the coming year. Now that you have both variables, this is how to use them:
DSCR = NOI/Total Debt Service
When using the formula, you should end up with a DSCR.
When it comes to total debt service, it is slightly more complicated to find an accurate one when income taxes are involved. This is because interest payments are tax deductible but principal repayments aren’t. That is why there is another formula that is used to more precisely evaluate a firm’s total debt service.
Total Debt Service= (Interest x (1 – Tax Rate)) + Principal
- A company has a NOI of $1,000,000 and a total debt service of $500,000. The DSCR is 2.
- A company has a total debt service of $14,000,000 and a NOI of $15,000,000. The DSCR is 1.07
- A company has a NOI of $80,000 and a total debt service of $110,000. The DSCR is 0.73
- A company has a total debt service of $25,000 and a NOI of $23,000. The DSCR is 0.92.
Positive Cash Flow vs. Negative Cash Flow
Usually commercial lenders will not lend money to a firm that has a DSCR of under 1.2, but what does that mean? A DSCR above 1 means positive cashflow, and a DSCR below 1 means negative cashflow. A DSCR above 1 means the company yields more than enough money to pay off the annual debt expenses. For example, a DSCR of 1.07 means that company makes 7% more income than is needed to pay the bills. On the other hand, a DSCR below 1 represents negative cashflow. This means you are not making enough money to pay off the annual debt expenses. For example, a DSCR of 0.92 means that a company only generated enough money to pay off 92% of the annual debt payments. That is why it is important to maintain a DSCR of at least 1 or higher but preferably above 1.2.