Debt service coverage ratio: Difference between revisions

Revision as of 02:32, 18 January 2019

Revision as of 18:56, 31 March 2019

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:<math>\text{Debt Service} = \text{Principal Repayment} + \text{Interest Payments} + \text{Lease Payments} </math> <ref name="freedictionary" />

To calculate an entity’sentity's debt coverage ratio, you first need to determine the entity’sentity's [[net operating income]]. To do this you must take the entity’sentity's total income and deduct any vacancy amounts and all operating expenses. Then take the net operating income and divide it by the property’sproperty's annual debt service, which is the total amount of all interest and principal paid on all of the property’sproperty's loans throughout the year.

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’sproperty'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 /><ref name="investopedia">[http://www.investopedia.com/terms/d/dscr.asp Debt-Service Coverage Ratio (DSCR) on Investopedia]</ref>

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===Example===

Let’sLet's say Mr. Jones is looking at an investment property with a net operating income of $36,000 and an annual debt service of $30,000. 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 Debt Service Ratio is also typically used to evaluate the quality

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Pretax provision for post-tax outlays = Post-tax outlays

For example, if a company’scompany's post-tax outlays consist of CPLTD of $90M and $10M in unfinanced CAPEX, and its noncash expenses are $100M,

then the company can apply $100M of cash inflow from operations to post-tax outlays without paying taxes on that $100M cash inflow. In this case, the pretax cash that the borrower must set aside for post-tax outlays would simply be $100M.

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For example, if post-tax outlays consist of CPLTD of $100M and noncash expenses are $50M, then the borrower can apply $50M of cash inflow

from operations directly against $50M of post-tax outlays without paying taxes on that $50M inflow, but the company must set aside $77M

(assuming a 35% income tax rate) to meet the remaining $50M of post-tax outlays. This company’scompany's pretax provision for post-tax outlays = $50M + $77M = $127M. <ref>[http://ebiz.rmahq.org/eBusPPRO/OnlineStore/ProductDetail/tabid/55/Productid/56403794/Default.aspx Andrukonis, David (May, 2013). "Pitfalls in ConventionalEarnings-Based DSCR Measures — and a Recommended Alternative". The RMA Journal.]</ref>

==See also==