Debt Service Ratio

The Debt Service Coverage Ratio (DSCR) measures the ability of a company to use its operating income to repay all its debt obligations, including repayment of principal and interest on both short-term and long-term debt. This ratio is often used when a company has any borrowings on its balance sheet such as bonds, loans, or lines of credit. It is also a commonly used ratio in a leveraged buyout transaction, to evaluate the debt capacity of the target company, along with other credit metrics such as total debt/EBITDA multiple, net debt/EBITDA multiple, interest coverage ratio, and fixed charge coverage ratio.

Debt Service coverage Ratio = EBITDA / (interest + Principle)

Debt Service coverage Ratio = (EBITDA-Capex) / (interest + Principle)

Where:

• EBITDA = Earnings Before Interest, Tax, Depreciation, and Amortization
• Principal = the total loan amount of short-term and long-term borrowings
• Interest = the interest payable on any borrowings
• Capex = Capital Expenditure

 Some companies might prefer to use the latter formula because capital expenditure is not expensed on the income statement but rather considered as an “investment”. Excluding CAPEX from EBITDA will give the company the actual amount of operating income available for debt repayment.

Interpretation of the Debt Service Coverage Ratio

A debt service coverage ratio of 1 or above indicates that a company is generating sufficient operating income to cover its annual debt and interest payments. As a general rule of thumb, an ideal ratio is 2 or higher. A ratio that high suggests that the company is capable of taking on more debt.

A ratio of less than 1 is not optimal because it reflects the company’s inability to service its current debt obligations with operating income alone. For example, a DSCR of 0.8 indicates that there is only enough operating income to cover 80% of the company’s debt payments.

Rather than just looking at an isolated number, it is better to consider a company’s debt service coverage ratio relative to the ratio of other companies in the same sector. If a company has a significantly higher DSCR than most of its competitors, that indicates superior debt management. A financial analyst may also want to look at a company’s ratio over time to see whether it is trending upward (improving) or downward (getting worse).