Debt service coverage ratio: Difference between revisions

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{{Short description|Financial metric}}

{{tone|date=July 2022}}

The '''debt service coverage ratio''' ('''DSCR'''), also known as "debt coverage ratio" (DCR), is a financial metric used to assess an entity's ability to generate enough cash to cover its [[Debt|debt service]] obligations, such as include interest, principal, and lease payments. The DSCR is calculated by dividing the operating income by the total amount of debt service due.

A higher DSCR indicates that an entity has a greater ability to service its debts. Banks and lenders often use a minimum DSCR ratio as a condition in the covenantcovenants, and a breach can sometimes be considered an act of [[Default (finance)|default]].

==Uses==

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

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=May 2024|reason=Does not have a reliable source}} but more aggressive banks would accept lower ratios, a risky practice that contributed to the [[Financialfinancial 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 (DSRA) is commonly used to ensure that loan repayment can be met even in periods with DSCR<1.0 <ref name="Corality Financial Modelling">{{Cite web |url=http://www.corality.com/tutorials/dscr-debt-service-coverage-ratio |title=Corality Debt Service Coverage Ratio Tutorial |access-date=2013-08-15 |archive-date=2013-07-18 |archive-url=https://web.archive.org/web/20130718014413/http://www.corality.com/tutorials/dscr-debt-service-coverage-ratio |url-status=dead }}</ref>

==Calculation==

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:{{math|Debt Service {{=}} (Principal Repayment) + (Interest Payments) + (Lease Payments)}}<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>

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 without or before financing. Thus, not included in operating expenses are financing costs (e.g., interests from loans), personal income tax of owners/investors, capital expenditure, and depreciation are not included in operating expenses.

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 principal 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 principal payments, DSCR reflects the cash flow situation of an entity.

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 income 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.

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Let's say Mr. Jones is looking at an investment property with a net operating income of {{US$|long=no|36000}} and an annual debt service of {{US$|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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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 {{US$|long=no|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,