The debt service coverage ration which is also commonly referred to as the ‘Debt Coverage Ratio’ is the measure of the cash available to pay the pay the current debt for principal, interest as well as lease payments. Is the Ration of the available cash flow statement to debt servicing and in general states the total operating income in terms of the multiple debts which is due within the duration of 1 complete year. This includes not only the interest and principal but also the lease payments and the sinking funds. The debt service coverage ratio is often used as a benchmark while measuring any individual or any corporations to produce cash which would be enough to cover the debt obligations including the lease payments. Most used in commercial banking, the debt service coverage ratio is that minimum ratio that is accepted by the lender which may be a certain type of loan situation.
The importance of DSCR in different sectors
No while in corporate finance the DSCR refers to the measurement of cash flow with respect to the debt obligation when it comes to government finance the DSCR is defined as that particular amount which belongs to the export earning that is required to cover up for the annual interests and principal payments which are on behalf of the country’s external debts. And in terms of personal finance the DSCR is nothing but the ratio which is required by the loan officers in the bank to evaluate the overall income property loans. Also it is always considered a better idea to have a higher value of the DSCR as it becomes easier to obtain the loan if the ratio is higher.
The basic formula for the Debt-Service Coverage Ratio
DSCR = Net Operating Income/ Total Debt Service
Net operating income= net income+ interest expense+ depreciation + other non cash items
Debt service= principal repayment+ interest payments+ lease payments
So what do the DSCR represent?
Now during the process of giving the loan, the lenders usually assess their borrower’ DSCR on a routinely basis before making a loan.
- If the value of the DSCR is anything but less than 1 then it refers to negative cash flow. This states the inability of the borrower pay the current debt obligations or cover them up without taking the help form any external source which means borrowing more! For example if the DSCR of the borrower is suppose .86, this means that he/she will be able to cover up for only 86% of the annual debt payments. Thus in most cases lenders avoid giving loans to such entities but if they have some strong external support to cover up for the debt then they may get the loan.
- If the value of DSCR is approximately 1, in this case some lenders may agree giving loans to the borrowers as this value shows only a slight decline in being able to cover the debt obligations.
- If the value of the DSCR is greater than 1, in this case the entity that is going to borrow the money has considerable income to pay for its current debts and the lender easily agree to give loans to them.
Thus in this the debt service coverage ratio plays a major role in terms of borrowing or issuing of a loan. It determines the abilities of the entity of how able it is to cover up for their debt obligations and thus is of great help to the lenders in many ways.