Debt service coverage ratio: Difference between revisions

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{{Short description|Financial metric assessing ability to cover debt payments}}

The '''debt service coverage ratio''' ('''DSCR'''), also known as "debt coverage ratio" (DCR), is the ratio of operating income available to debt servicing for interest, principal and lease payments. It is a popular [[Benchmarking|benchmark]] used in the measurement of an entity's (person or corporation) ability to produce enough cash to cover its debt (including lease) payments. The higher this ratio is, the easier it is to obtain a loan. The phrase is also used in commercial banking and may be expressed as a minimum ratio that is acceptable to a lender; it may be a loan condition. Breaching a DSCR covenant can, in some circumstances, be an act of [[Default (finance)|default]].

{{tone|date=July 2022}}

The '''debt service coverage ratio''' ('''DSCR'''), also known as the '''debt coverage ratio''' ('''DCR'''), is a [[financial ratio]] that measures an entity's ability to generate sufficient cash to cover its [[debt]] obligations, including interest, principal, and lease payments. It is calculated by dividing the [[net operating income]] (NOI) by the total debt service. A higher DSCR indicates stronger cash flow relative to debt commitments, while a ratio below 1 suggests insufficient funds to meet payments.<ref name="investopedia2">{{cite web |title=Debt-Service Coverage Ratio (DSCR) |url=http://www.investopedia.com/terms/d/dscr.asp |access-date=March 31, 2025 |website=Investopedia}}</ref> Lenders, such as banks, often set a minimum DSCR in loan covenants, where falling below this threshold may constitute a [[Default (finance)|default]].

In [[corporate finance]], the DSCR reflects cash flow available for annual debt payments, including sinking fund contributions.<ref name="freedictionary2">{{cite web |title=Debt-Service Coverage Ratio - DSCR |url=https://financial-dictionary.thefreedictionary.com/Debt+service+coverage+ratio |access-date=March 31, 2025 |website=The Free Dictionary}}</ref> In [[personal finance]], it aids loan officers in evaluating an individual’s debt repayment capacity. In [[commercial real estate]], it determines whether a property’s cash flow can sustain its debt, with typical minimums around 1.25.<ref>{{cite web |last=Freitas |first=Taylor |title=What Is Debt-Service Coverage Ratio? |url=https://www.bankrate.com/loans/small-business/what-is-dscr/ |access-date=2024-01-30 |website=Bankrate}}</ref>

==Uses==

In corporate finance, DSCR refers to the amount of cash flow available to meet annual interest and principal payments on debt, including sinking fund payments.<ref name="freedictionary">[http://financial-dictionary.thefreedictionary.com/Debt-Service+Coverage+Ratio+-+DSCR DSCR finance term by the Free Online Dictionary]</ref>

== Applications ==

In personal finance, DSCR refers to a ratio used by bank loan officers in determining debt servicing ability.

The DSCR serves distinct purposes across contexts. In corporate settings, it assesses cash flow for debt obligations, while in personal finance, it evaluates borrowing capacity.<ref name="freedictionary2" /> In real estate, it’s a key indicator of property viability. During the late 1990s and early 2000s, banks often required a DSCR of at least 1.2,{{Citation needed|date=May 2024|reason=Does not have a reliable source}} though some accepted lower ratios, a practice linked to the [[2008 financial crisis]]. A DSCR above 1 indicates adequate cash flow, while below 1 signals potential shortfall. In project finance, a '''Debt Service Reserve Account''' ('''DSRA''') may offset periods where DSCR falls below 1.<ref name="Corality Financial Modelling2">{{cite web |title=Corality Debt Service Coverage Ratio Tutorial |url=http://www.corality.com/tutorials/dscr-debt-service-coverage-ratio |url-status=dead |archive-url=https://web.archive.org/web/20130718014413/http://www.corality.com/tutorials/dscr-debt-service-coverage-ratio |archive-date=2013-07-18 |access-date=2013-08-15}}</ref>

In commercial real estate finance, DSCR is the primary measure to determine if a property will be able to sustain its debt based on cash flow. In the late 1990s and early 2000s banks typically required a DSCR of at least 1.2,{{Citation needed|date=January 2009}} but more aggressive banks would accept lower ratios, a risky practice that contributed to the [[Financial crisis of 2007–2010]]. A DSCR over 1 means that (in theory, as calculated to bank standards and assumptions) the entity generates sufficient cash flow to pay its debt obligations. A DSCR below 1.0 indicates that there is not enough cash flow to cover loan payments. In certain industries where non-recourse project finance is used, a Debt Service Reserve Account is commonly used to ensure that loan repayment can be met even in periods with DSCR<1.0 <ref name="Corality Financial Modelling">[http://www.corality.com/tutorials/dscr-debt-service-coverage-ratio Corality Debt Service Coverage Ratio Tutorial]</ref>

==Calculation==

In general, it is calculated by:

:<{{math>|DSCR \text{DSCR{=}} = \text{{sfrac|Net Operating Income} / \text{|Debt Service} </math>}}}

where:

:<math>\text{{math| Net Operating Income} {{=}} Adj. EBITDA \text{{=}} (Gross Operating Revenue}) -&minus; \text{(Operating Expenses)}} </math>

:<{{math>\text{|Debt Service} {{=}} \text{(Principal Repayment}) + \text{(Interest Payments}) + \text{(Lease Payments)}} </math> <ref>{{Cite web|url=https://propertymetrics.com/blog/how-to-calculate-the-debt-service-coverage-ratio-dscr/|title=How to Calculate the Debt Service Coverage Ratio (DSCR)|date=17 February 2016 }}<ref/ref>

To calculate an entity's debt coverage ratio, you first need to determine the entity's [[net operating income]] (NOI). NOI is the difference between gross revenue and operating expenses. NOI is meant to reflect the true income of an entity or an operation. Thus,without notor includedbefore infinancing. operating expenses areThus, financing costs (e.g., interests from loans), personal income tax of owners/investors, capital expenditure, and depreciation. are not included in operating expenses.

:<math>\text{Debt Service} = \text{Principal Repayment} + \text{Interest Payments} + \text{Lease Payments} </math> <ref>https://propertymetrics.com/blog/how-to-calculate-the-debt-service-coverage-ratio-dscr/<ref/>

Debt Serviceservice are costs and payments related to financing. Interests and lease payments are true costs resulting from taking loans or borrowing assets. Paying down the principleprincipal of a loan does not change the net equity/liquidation value of an entity; however, it reduces the cash an entity processes (in exchange of decreasing loan liability or increasing equity in an asset). Thus, by accounting for principleprincipal payments, DSCR reflects the cash flow situation of an entity.

To calculate an entity's debt coverage ratio, you first need to determine the entity's [[net operating income]] (NOI). NOI is the difference between gross revenue and operating expenses. NOI is meant to reflect the true income of an entity or an operation. Thus, not included in operating expenses are financing costs (e.g. interests from loans), personal income tax of owners/investors, capital expenditure and depreciation.

For example, if a property has a debt coverage ratio of less than one, the income that property generates is not enough to cover the mortgage payments and the property's [[operating expense]]s. A property with a debt coverage ratio of .8 only generates enough income to pay for 80 percent of the yearly debt payments. However, if a property has a debt coverage ratio of more than 1, the property does generate enough revenueincome to cover annual debt payments. For example, a property with a debt coverage ratio of 1.5 generates enough income to pay all of the annual debt expenses, all of the operating expenses and actually generates fifty percent more income than is required to pay these bills.

Debt Service are costs and payments related to financing. Interests and lease payments are true costs resulting from taking loans. Paying down the principle of a loan does not change the net equity/liquidation value of an entity; however, it reduces the cash an entity processes (in exchange of decreasing loan liability or increasing equity in an asset). Thus, by accounting for principle payments, DSCR reflects the cash flow situation of an entity.

In the commercial real estate industry, the minimum DSCR set by lenders is 1.25, meaning that the property's net operating income (NOI) is 25% greater than the annual debt service.<ref>{{Cite web |last=Freitas |first=Taylor |title=What Is Debt-Service Coverage Ratio? |url=https://www.bankrate.com/loans/small-business/what-is-dscr/ |access-date=2024-01-30 |website=Bankrate |language=en-US}}</ref>

For example, if a property has a debt coverage ratio of less than one, the income that property generates is not enough to cover the mortgage payments and the property's [[operating expense]]s. A property with a debt coverage ratio of .8 only generates enough income to pay for 80 percent of the yearly debt payments. However, if a property has a debt coverage ratio of more than 1, the property does generate enough revenue to cover annual debt payments. For example, a property with a debt coverage ratio of 1.5 generates enough income to pay all of the annual debt expenses, all of the operating expenses and actually generates fifty percent more income than is required to pay these bills.

A DSCR of less than 1 would mean a negative cash flow. A DSCR of less than 1, say .95, would mean that there is only enough net operating income to cover 95% of annual debt payments. For example, in the context of personal finance, this would mean that the borrower would have to delve into his or her personal funds every month to keep the project afloat. Generally, lenders frown on a negative cash flow, but some allow it if the borrower has strong outside income.<ref name="freedictionary">[http://financial-dictionary.thefreedictionary.com/Debt-Service+Coverage+Ratio+-+DSCR DSCR finance term by the Free Online Dictionary]</ref><ref name="investopedia">[http://www.investopedia.com/terms/d/dscr.asp Debt-Service Coverage Ratio (DSCR) on Investopedia]</ref>

Typically, most commercial banks require the ratio of {{val|1.15–115|–|1.35}} {{tooltip|×|times}} ({{pars|{{sfrac|{{abbr|NOI|net operating income}} or NOI /| annual debt service)}}|153%}} to ensure cash flow sufficient to cover loan payments is available on an ongoing basis.

===Example===

Let's say Mr. Jones is looking at an investment property with a net operating income of {{US$36,000|long=no|36000}} and an annual debt service of {{US$30,000|long=no|30000}}. The debt coverage ratio for this property would be 1.2 and Mr. Jones would know the property generates 20 percent more than is required to pay the annual mortgage payment.

The Debtdebt Serviceservice Ratiocoverage ratio is also typically used to evaluate the quality

of a portfolio of mortgages. For example, on June 19, 2008, a popular

US rating agency, Standard & Poors, reported that it lowered its credit

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stated in a press release that it had lowered the credit ratings of

four certificates in the Bank of America Commercial Mortgage Inc.

2005-12005–1 series, stating that the downgrades "reflect the credit

deterioration of the pool". They further go on to state that this

downgrade resulted from the fact that eight specific loans in the

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times.

The debt service coverage ratio provides a useful indicator of financial strength. Standard & Poors reported that the total pool consisted, as of June 10, 2008, of 135 loans, with an aggregate trust balance of {{US$|long=no|2.052 billion}}.

The Debt Service Ratio, or debt service coverage, provides a useful

They indicate that there were, as of that date, eight loans with a DSC of lower than

indicator of financial strength. Standard & Poors reported that

the total pool consisted, as of June 10, 2008, of 135 loans, with

an aggregate trust balance of $2.052 billion. They indicate that

there were, as of that date, eight loans with a DSC of lower than

1.0x. This means that the net funds coming in from rental of the

commercial properties are not covering the mortgage costs. Now,

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just what the DSC is at a particular point in time, but also how

much it has changed from when the loan was last evaluated. The

S&P press release tells us this.
It indicates that of the eight loans which are "underwater",

loans which are "underwater", they have an average balance of {{US$|long=no|10.1}}

million, and an average decline in DSC of 38% since the loans

were issued.

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entire pool of 135 loans? The Standard and Poors press release

provides this number, indicating that the weighted average DSC

for the entire pool is 1.76x, or 1.76 {{tooltip|×|times}}. Again, this is just

Again, this is just a snapshot now.
The key question that DSC can help you answer,

is this better or worse, from when all the loans in the pool were

first made? The S&P press release provides this also, explaining

that the original weighted average DSC for the entire pool of 135

loans was 1.66x, or 1.66 {{tooltip|×|times}}.

In this way, the DSC (debt service coverage) ratio provides a way to assess the financial quality, and the associated risk level, of this pool of loans, and shows the surprising result that despite some loans experiencing DSC below 1, the overall DSC of the entire pool has improved, from 1.66 {{tooltip|×|times}} to 1.76 {{tooltip|×|times}}. This is pretty much what

a good loan portfolio should look like, with DSC improving over

time, as the loans are paid down, and a small percentage, in this

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this does not necessarily mean they will default.

===Pre-Tax Provision Method===

Income taxes present a special problem to DSCR calculation and interpretation. While, in concept, DSCR is the ratio of cash flow available for debt service to required debt service, in practice &ndash; because interest is a tax-deductible expense and principal is not &ndash; there is no one figure that represents an amount of cash generated from operations that is both ''fully available'' for debt service and ''the only cash available'' for debt service.

While [[Earnings before interest, taxes, depreciation and amortization | Earnings Before Interest, Taxes, Depreciation and Amortization]] (EBITDA) is an appropriate measure of a company's ability to make interest-only payments (assuming that expected change in working capital is zero), [[EBIDA]] (without the "T") is a more appropriate indicator of a company's ability to make required principal payments. Ignoring these distinctions can lead to DSCR values that overstate or understate a company's debt service capacity. The Pre-Tax Provision Method provides a single ratio that expresses overall debt service capacity reliably given these challenges.

Debt Service Coverage Ratio as calculated using the Pre-Tax Provision Method answers the following question: How many times greater was the company's EBITDA than its critical EBITDA value, where critical EBITDA is that which just covers its
:[[Interest obligations]] + [[Principal obligations]] + Tax Expense ''assuming minimum sufficient income'' + Other necessary expenditures[[expenditure]]s not treated as accounting expenses, like dividends and [[CAPEX]].

The DSCR calculation under the Pre-Tax Provision Method is '''
:{{big|{{sfrac|EBITDA''' / |('''Interest''') + '''(Pre-tax Provision for Post-Tax Outlays''')}}}},
where '''Pre-tax Provision for Post-tax Outlays''' is the amount of pretax cash that must be set aside to meet required post-tax outlays, i.e.,
:CPLTD + (Unfinanced CAPEX) + Dividends.
The provision can be calculated as follows:

''If'' (noncash expenses (depreciation) + (depletion) + (amortization) > (post-tax outlays), ''then''

:(Pretax provision for post-tax outlays) = (Post-tax outlays)

For example, if a company's post-tax outlays consist of CPLTD of {{US$|long=no|90M}} and {{US$|long=no|10M}} in unfinanced CAPEX, and its noncash expenses are {{US$|long=no|100M}},

then the company can apply {{US$|long=no|100M}} of cash inflow from operations to post-tax outlays without paying taxes on that {{US$|long=no|100M}} cash inflow. In this case, the pretax cash that the borrower must set aside for post-tax outlays would simply be {{US$|long=no|100M}}.

''If'' (post-tax outlays) > (noncash expenses), ''then''

:(Pretax provision for post-tax outlays) = (Noncash expenses) + {{sfrac|(post-tax outlays) -&minus; (noncash expenses) /| (1- &minus; (income tax rate)}}

For example, if post-tax outlays consist of CPLTD of {{US$|long=no|100M}} and noncash expenses are {{US$|long=no|50M}}, then the borrower can apply {{US$|long=no|50M}} of cash inflow

from operations directly against {{US$|long=no|50M}} of post-tax outlays without paying taxes on that {{US$|long=no|50M}} inflow, but the company must set aside {{US$|long=no|77M}}

(assuming a 35% income tax rate) to meet the remaining {{US$|long=no|50M}} of post-tax outlays. This company's pretax provision for post-tax outlays = {{US$|long=no|50M}} + {{US$|long=no|77M}} = {{US$|long=no|127M}}. <ref>{{Cite web |url=http://ebiz.rmahq.org/eBusPPRO/OnlineStore/ProductDetail/tabid/55/Productid/56403794/Default.aspx |title=Andrukonis, David (May, 2013). "Pitfalls in ConventionalEarnings-Based DSCR Measures — and a Recommended Alternative". The RMA Journal. |access-date=2013-05-23 |archive-url=https://archive.istoday/20130616131836/http://ebiz.rmahq.org/eBusPPRO/OnlineStore/ProductDetail/tabid/55/Productid/56403794/Default.aspx |archive-date=2013-06-16 |dead-url-status=yesdead }}</ref>

==See also==

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*[[Operating leverage]]

*[[Project Finance]]

*[[Cash-flow-to-debt ratio]]

==References==