Debt service coverage ratio definition

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What is the Debt Service Coverage Ratio?

The debt service coverage ratio measures whether a business has sufficient cash flow to pay its debt obligations. In essence, it compares cash flows to debt service payments. A positive debt service ratio indicates that an organization’s cash flows can cover all offsetting debt payments, while a negative ratio indicates that the business must contribute additional funds to pay for the annual loan payments. This is only possible if the business has a substantial cash reserve, or access to additional funds from investors. Lenders are unlikely to lend additional funds to a business that exhibits a negative debt service coverage ratio, and may require borrowers to maintain a debt service coverage ratio of greater than 1 over the life of their loans.

A very high debt service coverage ratio gives a business a substantial cushion to pay for unexpected or unplanned expenditures, or if market conditions result in a significant decline in future income.

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How to Calculate the Debt Service Coverage Ratio

To calculate the ratio, you will need a company’s net operating income (essentially its earnings before interest and taxes), as well as its total debt service, which is its scheduled interest, principal, and lease payments for the coming year. The formula is as follows:

Net annual operating income ÷ Total of annual loan payments = Debt service coverage ratio

For more accuracy, reduce the total debt service figure by the beneficial effect of the deductibility of interest payments on income taxes.

It may be necessary to calculate this ratio regularly and track it on a trend line, since the net annual operating income figure may vary substantially over time. The debt service figure may also vary, if the debt is subject to a variable interest rate. These two factors can result in a great degree of variability in the debt service coverage ratio’s results.

Example of the Debt Service Coverage Ratio

A business generates $400,000 of cash flow per year, and its total annual loan payments are $360,000. This yields a debt service ratio of 1.11, meaning that the firm generates 11% more cash than it needs to pay for the annual debt service. The calculation is as follows:

$400,000 Net annual operating income ÷ $360,000 Total of annual loan payments = 1.11 Debt service coverage ratio

Problems with the Debt Service Coverage Ratio

There are several problems associated with the debt service coverage ratio, which are as follows:

  • Sensitivity to calculation inputs. Different organizations may define "operating income" differently (e.g., EBITDA vs. net operating income), leading to inconsistent ratio results.

  • Ignores future cash flow variability. The ratio is typically based on historical or projected financial data, which may not account for future fluctuations in cash flows due to economic or business conditions. Thus, a company with volatile income might show a favorable ratio based on one good year but struggle to meet debt obligations in subsequent periods.

  • Limited insight into liquidity. The ratio does not account for cash reserves or other sources of liquidity that could be used to service debt.

  • Ignores the quality of income. The ratio does not differentiate between recurring and non-recurring income. One-time gains could inflate the ratio, giving a false impression of debt-servicing ability.

  • Does not account for capital expenditures. The ratio focuses on debt obligations and operating income, but ignores required capital expenditures, which could reduce the cash available to service debt. Thus, a high ratio might suggest strong debt coverage, but if significant capital outlays are required, the company may still face financial strain.

  • Ignores changes in interest rates. If a company’s debt includes variable interest rates, the ratio may not accurately reflect future debt service obligations as rates fluctuate.

  • Overlooks debt refinancing risks. The ratio does not consider the company’s ability to refinance debt when it matures, which can be critical if the company lacks sufficient cash flow for repayment.

  • Does not address debt maturity. The ratio typically considers annual debt service and does not account for the maturity profile of long-term debt, which could create large future payment obligations. For example, it does not assess the risk of balloon payments that may require significant cash outlays at maturity.

  • Risk of manipulation. Companies can manipulate the components of the ratio (e.g., adjusting income recognition or deferring expenses) to present a more favorable ratio. Or, they might structure debt to minimize immediate obligations, inflating the ratio while hiding long-term repayment challenges.

Interest Coverage Ratio vs. Debt Service Coverage Ratio

The interest coverage ratio shows how many times an organization’s operating profit will pay for just the interest on its debts. This approach varies from the debt service coverage ratio, which also addresses the ability of a company to pay the principal portion of its debts. As such, the debt service coverage ratio is more realistic, except in cases where a business does not have to pay any principal within the next year - in which case the results of the two measures should be the same. In both situations, if the ratios result in a figure of less than 1, then the entity is not generating sufficient income to pay for its ongoing debt obligations, making it a risky borrower for any prospective lender.