Debt Service Coverage Ratio: What Is It and How To Calculate It
No matter where you’re starting from, debt can make or break the financial situation of both individuals and businesses. On one hand, debt is often necessary to get the ball rolling for a startup or expanding business. For individuals, paying off debt can help you build credit and purchase things like vehicles and cars. As they say, you need to spend money to make money. On the other hand, accumulating too much debt or failing to pay it off can create legal trouble for small businesses and scare away investors, and for individuals, it can tank your credit score. One way that businesses assess their ability to pay off these debts is by calculating their debt service coverage ratio. Unless you have a team of accountants handling your finances, chances are that you’ll be making this calculation yourself. No need to worry though, it’s not as scary as it sounds. As you read on, you’ll gain an understanding of what service debt coverage is and how you can calculate it yourself, helping you stay on top of your finances and reassure both yourself and investors that you aren’t acquiring more debt than you can pay off.
What is a Debt Service Coverage Ratio?
While debt service coverage ratios (DSCR) are applicable in corporate, government, and personal finance, we’ll be mostly focusing on its use in the corporate world as that is its most common application. Essentially a debt service coverage ratio measures a company's cash flow and its ability to pay off debt obligations. To clarify, cash flow is the amount of money moving in and out of the business. So, positive cash flow means that the company is making more money than it is spending, whereas negative cash flow means that more money is being spent than earned. In the case of governments, the debt service coverage ratio is the amount of money earned through exports in order to pay off principal and interest payments on external debt. For individuals, the debt service coverage ratio is used to assess one’s ability to pay off income property loans. Income properties are pieces of real estate purchased by an individual with the intention of making a profit from said purchase. In any case, the debt service coverage ratio is necessary for lenders to assess the risk presented by their borrowers and set terms for their loans accordingly.
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As we mentioned above, borrowing money is often an essential part of starting a business. However, calculating your DSCR is only one of the many factors that play into choosing the right business loan. Seek Capital makes it easy for businesses to receive funding, with a free application that only takes minutes to complete, as well as flexible payment options and pre-approval in under 2 hours. Additionally, Seek Capital makes it easy to compare credit cards, so that you can start spending smart. With funding available from $5,000-$50,000, it doesn’t matter where you are in your entrepreneurial journey. With great rates and fast funding, Seek Capital can help you kickstart your dream.
How to Calculate your Debt Service Coverage Ratio
There are several calculations involved in calculating your DSCR. In each of them, there are several key terms that you should familiarize yourself with before whipping out your calculator and diving in. Let’s review.
EBITA
EBITA stands for Earnings Before Interest, Tax, Depreciation, and Amortization (which is a mouthful so we’re glad that there’s an abbreviation). This equates to a company’s profits before any of these net deductions are made. In short, EBITA is a measure of a company's financial performance, and in this case, is a replacement for net income. It’s important to note, however, that EBITA does not include capital investments such as property and equipment.
Principal
In short, the principal is the initial amount of money that you agree to pay back when you borrow money from a lender. So if you borrow $10,000 from a lender, your principal is $10,000. However, when paying back your loan, the principal is only one part of your payment. The other part is the interest which we will cover next.
Interest
Interest is basically a fee for borrowing money from a lender. Oftentimes, your interest rate will be a percentage of your principal. Those with a higher credit score or better credit history will receive a lower interest rate than those with a worse credit history. Furthermore, interest actually gets paid back before the principal, so at first, a majority of your payments will go towards interest. As you pay back more of your loan, you’ll be paying more in principal and less in interest.
Capex
Capex is how the cool kids (or accountants rather) refer to capital expenditure. Capital expenditure is the funds used to expand a company through investments like real estate and equipment. Not only is it used for growth, but also for maintenance on existing assets such as repairing a roof or upgrading a conveyor belt.
The Equation
Now for the part that we’ve all been waiting for: the equation used for calculating your company's DSCR. (Drumroll please). The equation is: DSCR=EBITA/TDS TDS stands for Total Debt Services and is calculated with this equation: TDS = Interest x (1-Tax Rate) + Principal For businesses that consider CAPEX as an investment rather than expensing it on an income statement , a slightly different equation should be used that more accurately represents the amount of income available for debt repayment. DSCR=EBITA-CapEx /TDS Let’s take a look at an example to help clarify the equation. Francis, an inspired entrepreneur, starts a new high-end coat hanger business. First Francis calculates their EBITA to be 25,000, and their capital expenditure for the year is $3,000. Additionally, Francis’s annual debt payment (interest+principal) is $20,000 25,000-3,000 / 20,000 = 1.1% While Francis’s company has a positive DSCR (above 1%) they just barely have enough to pay off their debts. Next, we’ll talk about optimal DSCR rates and what they mean for businesses.
What Do The Numbers Mean?
Your DSCR helps lenders determine your company's eligibility for a loan. For instance, if your company has a DSCR under 1%, it means that they are making less money than required to pay off their debts, and thus are unable to pay off a loan. Furthermore, a company like Francis’s with a 1.1% DSCR is considered at risk, meaning a slight change in income could put them in a position to be unable to pay off debts. Typically, lenders look for a DSCR of 1.25% to 1.5% . This means that even after paying off debts, the company will still produce additional income. Additionally, the larger economic climate can impact the rate at which loans are given out. For instance, a growing economy means that lenders may be more willing to give out loans to those with lower DSCR’s, and in times of widespread economic hardship, the inverse is true. However, it should be noted that when lenders give out an excess of loans to those with subprime DSCR’s a bubble can be created, which was one of the major causes of the Great Recession of 2008.
DSCR vs Interest Coverage Ratio
If you are delving into the world of calculating a DSCR, you’ve likely also heard of an interest coverage ratio or an ICR. Calculating an ICR is very similar to a DSCR, however, it exclusively applies to a company’s ability to pay off the interest on debts for a specific period. To calculate ICR simply divide your EBITA by the number of your interest payments due for that period.
Final Thoughts
While DSCR is important to determining a company's eligibility for a loan, the number shouldn’t be looked at in isolation. Instead, it’s important to view DSCR in a greater context, such as how it compares to similar businesses within its industry. For instance, if a company has a DSCR that is much higher than its competitors, it is clear that they have superior debt management. It’s also important to consider a company's DSCR over time. If the DSCR steadily decreases over the course of several years, this could be a red flag that the company is experiencing financial trouble. If the opposite is true and the DSCR sees a steady increase, the company is likely to perform financially well enough to pay back its debts. Furthermore, the stage at which the company is at in its lifetime will impact its eligibility to borrow. A lower DSCR is expected from smaller businesses or businesses that are just starting out compared to mature businesses, so if you run a startup and your rate isn’t perfect, there’s no need to be discouraged. For any business, however, managing your debt is of the utmost importance, and knowing how to calculate your debt service coverage ratio is one key piece of the puzzle. Sources: Debt Coverage Ratio | Multi-Family Loans Capital Expenditure | Investopedia Income Statement | Corporate Finance Institute