Debt service coverage ratio (DSCR) is a commonly used matric to ascertain the ability of a firm to service its debt obligations. It shows whether the firm has generated enough earnings to repay its debt obligations. The higher the DSCR, the better it is. A higher DSCR indicates that the firm has generated sufficient income to repay its debt obligations. On the contrary, a DSCR of less than 1 would mean that the firm has not generated enough income and may have to struggle to repay its debt obligations.
How to Calculate Debt Service Coverage Ratio
Debt service coverage ratio can be calculated with the help of the following formula:
DSCR= (Profit after tax + Depreciation + Interest + Lease payments)/ (Repayment of Principal + Repayment of Interest + Lease Payments)
Why DSCR
DSCR throws light on the financial health of a firm. It helps the lender to identify whether the borrower is able to service his debt obligations, both principal and interest on time. It also helps the lender to find out how much extra earnings the firm retains after servicing its debt obligations.
| When DSCR is greater than 1 | It means the firm has generated more earnings than what is required to service its debt obligations. The firm has extra cash balance after servicing its debt obligations. |
| When DSCR is equal to 1 | It means that the firm has generated only that portion of income which is necessary to service its debt obligations. |
| When DSCR is less than 1 | It means that the firm has not generated sufficient income to repay its debt obligations. The firm may have to resort to additional funding to repay its debt obligations. |
Conclusion
DSCR indicates the ability of an enterprise to repay its debt obligations. It also shows the extra cushion available to the enterprise to service its debt obligations. A higher DSCR is favourable than a lower DSCR. A higher DSCR is the indication that there is more income available with the enterprise to service its debt obligations.