Debt Service Coverage Ratio (DSCR) helps in concluding how able is the company to use its operating income to repay all its debt obligations which includes repayment of principal and interest on both short-term and long-term debt. DSCR is boright into use when the balance sheet of a company shows borrowings such as bonds and loans. Usually, the ratio is used in a leveraged buyout transaction to determine the debt capacity of the concerned company.

Unlike the debt ratio, all the debt related expenses are included in debt service coverage ratio such as interest expense and other obligations like pension and sinking fund obligation. In this way, the DSCR is more telling of a company’s ability to pay its debt than the debt ratio.

Formula

The debt service coverage ratio formula is calculated by dividing net operating income by total debt service.

Debt Service Coverage Ratio = Operating Income/Total Debt Service Costs

When there is cash left after payment of all the operating expenses that is known as net operating income. This is genrally referred to as earnings before interest and taxes or EBIT. Net operating income is usually shown separately on the income statement.

Example

Vovno Shoe Store is looking to renovate its storefront, but it doesn’t have sufficient cash to pay for the renovation itself. Therefore, the owner approaches a bank or two to get the loan passed. The owner is a little worried whether he is going to get the loan or not because he already has few loans on his head.

According to his financial statements and documents, Burton’s had the following:

Net Operating Profits:          $150,000

Interest Expense:                  $55,000

Principle Payments:              $35,000

Sinking Fund Obligations:    $25,000

Here’s how the calculation will be done:

DSCR = $1,50,000/$55,000 + $35,000 + $25,000

DSCR = 1.3

The above figure shows that Vovno has a ratio of 1.3. This indicates that Vovno makes sufficient operating profits to pay its current debt service costs and still be left with 30 percent of his profits.