What is Debt Service Coverage Ratio (DSCR)CASAPLORERTrusted & Transparent
Debt Service Coverage Ratio
The debt service coverage ratio shows how capable someone is of repaying back their debts based on their level of income. The DSCR is the ratio of net operating income over the outstanding debt obligations of an entity or person during a specific period. Debt obligations typically include principal, interest, and any other money owed to another entity or person. The DSCR has multiple uses in corporate finance, government finance, personal finance and commercial real estate finance.
What You Should Know?
- The debt service coverage ratio shows to what extent a person’s or entity’s net operating income covers their debt obligations for the year.
- DSCR is calculated as net operating income over total debt service, which includes the principal, interest, and any other money owed, such as lease payments
- Lenders use DSCR to evaluate if a borrower will be able to pay back their debt obligations in the future
- The interest coverage ratio is calculated as net operating income over total interest for a specific period of time
What is the Debt Service Coverage Ratio?
The debt service coverage ratio is a measure that tells us information on a person’s or entity’s cash flows for the year, specifically if the net operating income can cover the debt service. Lenders use this information to assess the creditworthiness of the individual or entity. If the borrower’s DSCR is less than 1, lenders will probably not qualify them for a loan since the borrower’s income will not cover the principal and interest payments that have to be paid back to the lender.
Companies can use DSCR to see how much more debt they can take before the net operating income does not suffice to pay for the debt anymore. For example, imagine that the DSCR of a company is 1.4, and the lender has a debt service coverage ratio requirement of 1.2. This means that the company can still borrow 20% of the amount of its current debt.
How is the Debt Service Coverage Ratio calculated?
To calculate the Debt Service Coverage Ratio, we use the following formula:
Net Operating Income - Net operating income can be calculated as the total income generated minus the operating expenses of a firm. Financing costs, such as principal and interest payments are not included when calculating net operating income. Some lenders use EBITDA as the numerator, which is the same as NOI. EBITDA stands for earnings before interest, taxes, depreciation and amortization.
Total Debt Service - These include the principal and interest payments made throughout the year, which reduce the cash flows of a business. For a mortgage borrower, the total debt service would equal the annual mortgage payments made. If an entity has a short-term debt and a long-term debt, then the short-term debt and the current portion of the long-term one should be included in the total debt service. Moreover, the lease payments owed should be taken into account when calculating the DSCR of a firm.
Debt Service Coverage Ratio - Example
A rental property was purchased using a 30-year mortgage of $350,000, with a 20% down payment and an interest rate of 3%. $3,000 of rental income is generated every month. There is a vacancy rate of 8.33% and operational costs amount to $900 per month. What is the DSCR?
|Total Income||= $3,000 x 12 x (1 - 0.0833) = $33,000|
|Operating Expenses||= 12 x $900 = $10,800|
|Net Operating Income||= $33,000 - $10,800 = $22,200|
|Mortgage Payment||= $1,180|
|Total Debt Service||= 12 x $1,180 = $14,160|
|DSCR||= $22,200 / $14,160 = 1.567|
How to interpret the Debt Service Coverage Ratio?
The DSCR is one of the measures that tells lenders whether you are financially capable to pay back what you owe. Lenders may have different debt service coverage ratio requirements. Some lenders may consider that the borrower has defaulted if their DSCR falls below a certain level during the loan’s life.
If the DSCR is bigger than 1, it means that the person or entity generates sufficient net operating income to cover more than the existing debt obligations. For example, if the DSCR is equal to 1.4, this means that the entity is able to pay back all obligations and has the financial means to cover 40% more of its current debt service.
If the DSCR is equal to 1, it means that the net operating income generated is exactly equal to the outstanding debt obligations for the year. Lenders may not lend if your DSCR is 1 since a small fluctuation in your income will mean that you won’t be able to cover your obligations in full.
If the DSCR is less than 1, it means that there is a negative cash flow, where there is more money coming out than flowing in. For example, if the DSCR is equal to 0.85, then the net operating income will not be able to pay for 15% of the total debt service. Unless the lender is convinced that the borrower will be able to pay back what they owe through other resources, the lender will probably not lend them if they have a DSCR lower than 1.
Uses of DSCR
The Debt Service Coverage Ratio is used in many areas, including the following:Personal Finance
In personal finance, DSCR is used by lenders to determine how capable an applicant is of repaying their debt obligations based on their level of income. By looking at the DSCR, the lender can see what portion of the debt can someone’s income cover. When the ratio is below 1, it means that the income is not sufficient to pay the debt, which may disqualify you for a loan. Some lenders may even require you to maintain a certain DSCR ratio while you still have a balance owing to them. If your ratio falls below the benchmark, then the lender may consider you have defaulted on your loan.Corporate Finance
In corporate finance, DSCR measures the ability of a company to pay its current debts through its available cash flows. If the ratio is less than 1, the firm will not be able to pay debt obligations as they come due because there will not be enough cash available. The DSCR is an indicator of a firm’s financial standing. This means that lenders, investors, and other interested parties can use it to assess how the debt the firm uses compares to the cash flows it generates.
The DSCR of a certain company is also useful to other firms that may be looking to acquire it in order to take advantage of their debt capacity. In other words, companies that have reached their maximum debt capacity may acquire firms that have used little or no debt at all.
Some companies prefer to adjust the formula of DSCR to account for capital expenditure, which is typically considered an investment and is not deducted from the earnings of the company. The formula now becomes:
The government of a country may borrow money from the governments of other countries or foreign creditors to meet its economic needs. The DSCR ratio in public finance is calculated as the earnings generated from exports over its debt from foreign creditors.Commercial Real Estate Finance
DSCR can be used to evaluate a property and the income it will generate towards the debt that was taken to acquire it. For example, if it is estimated that a property will generate a net operating income of $1,000,000 in one year and the debt service amounts to $250,000, then the DSCR of the property will be equal to 4. The property’s net operating income can cover the debt obligation 4 times.
DSCR vs Interest coverage ratio
The interest coverage ratio is another metric that is used to assess the financial stability of a firm. It is calculated as net operating income or EBIT over the interest payments to be made throughout a certain period. The ratio does not take into account the principal payments made on debts, which makes it somewhat less comprehensive than the debt service coverage ratio. The DSCR takes into account both principal and interest payments.
For example, imagine that during a certain year your annual income is $40,000. You have a mortgage, for which you will have to pay $6,000 in interest and $7,000 in principal throughout the whole year. In this scenario, the DSCR would be 3.077, while the interest coverage ratio would be 6.667.
DSCR and Income Taxes
There is actually an issue with the DSCR formula that we explained below, which relates to how principal and interest payment are treated when filing your income taxes. Interest payments are tax-deductible, which means that you will save some money on taxes, while principal payments are not. To give a fairer representation of the debt service coverage ratio, the formula for the total debt services should be:
Total Debt Service = Principal + Interest (1 - Tax Rate)
What is a good DSCR?
Typically, a good DSCR is considered anything above 1.25. To lend amounts exceeding $350,000, the Small Business Association in the U.S. requires borrowers to have a ratio of at least 1.15.