Accounting provides many analytical tools to evaluate the financial health of any company or the revenue-generating potential of a property. One such tool is the debt service coverage ratio (DSCR), that helps determine the debt repayment abilities of any business entity or property. A calculator is also provided, which you may use.
For a business to expand and prosper, the liquidity and financial boost provided by loans is a necessity. As long as the business entity generates enough cash to pay back interest on loans and covers all of its day-to-day expenses, it can be classified as a sustainable business. The accounting tool which helps quantify the debt repayment ability of an entity, against that of any business entity, is debt service coverage ratio (DSCR).
Simply put, DSCR is obtained by dividing the net income generated by a business entity or individual, by the total debt plus interest on loans, that a business is liable for. While calculating the income generated by a business, all running costs and other expenses are subtracted. The debt service costs include principal payment amounts, plus interest and in case of real estate businesses, the lease value is included in the debt servicing.
The ratio can be defined in three different ways, in context of personal finance, government finance, and real estate businesses. In case of personal finance, it is the ratio of an individual’s income to the debt servicing amount. In case of a business, it’s the ratio of cash flow generated by a business after expenses, to the total debt service payments, which includes principal payment.
In case of a real estate business, it is calculated by dividing the cash flow generated by a property, to the lease and mortgage payments that need to be paid for it. If the debt service value is lower than the income of a business entity, then the DSCR is greater than 1. On the other hand, if it is less than 1, it indicates an overall negative cash flow.
Here’s the calculation formula:
Debt Service Coverage Ratio = (Net Operating Income/Debt Service Payments)
To get an accurate value of this parameter, you need information about the net operating income of the business, after expenses and the total debt service payments. Once you have these values, the DSCR is just one mathematical calculation away.
When calculating the debt repayment ability of a real estate business, the debt service payments will also include lease payments, if it’s a rental property. Banks require a DSCR ratio greater than 1.3, for a loan application from the business to go through.
Here is a simple calculator, which you may use, to get the DSCR value accurately. Just calculate the net operating income for a financial year, after expenses and business management costs, along with the total annual debt service. Enter them in the calculator below to get the value directly.
As long as a business can maintain, or a property can maintain a coverage ratio greater than 1, debt service payments and interest on loans can be paid back to stay afloat. Problems start when the DSCR plunges below 1 and the property or business can’t generate enough income to pay back the interest on debts and loans. That’s when some drastic decisions need to be taken.