DSCR Meaning
Debt Service Coverage Ratio (DSCR) calculates the ability of companies to manage their current Debt obligations using the available resources. The computation of this ratio allows stakeholders to assess the company’s financial state and check if it is capable enough to repay its outstanding long-term and short-term dues.
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When the DSCR ratio is known, it becomes easier for lending institutions to decide whether to approve a company’s loan application, given their current availability of resources. The higher the ratio, the higher the firms’ chances of obtaining credits or loans.
Table of contents
- DSCR Meaning
- How Does DSCR Work?
- Formula
- Interpretation
- DSCR Calculation Examples
- Example 1 (Putting the Formula)
- Example 2 (Using Excel)
- Relevance
- Frequently Asked Questions (FAQs)
- Recommended Articles
Key Takeaways
- The debt service coverage ratio (DSCR) is the ratio that helps assess the ability of a company to repay its debts.
- It is derived by dividing the net operating income by the total debt service.
- If this ratio is less than one, it means that the net operating income generated by the company is not enough to cover all the debt-related obligations of the company.
- A bank, however, does not consider the DSCR alone to approve the loan. Instead, it looks into the company’s way of managing financial obligations in the past.
How Does DSCR Work?
DSCR is yet another tool to check the capacity of businesses to pay back their loan. The other two metrics include the debt-to-equity ratio and the debt-to-total assets ratio. In short, DSCR is an indicator of an organization’s financial health.
It is derived when the Net Operating income is divided by debt service. The net operating income is the earnings before interest and tax (EBIT). As the name suggests, it is the amount from which the interest and tax payments have not yet been deducted. However, in this case, the net operating income is the earnings before interest, tax, depreciation, and amortization (EBITDA).
The next factor in determining the ratio is the total debt service, which includes all housing and non-housing obligations of a borrower. This helps lenders derive the debt service coverage ratio for real estate or other loans to understand how capable the finance seeker is of paying them back on time.
Formula
DSCR is calculated using the following debt service coverage ratio formula:
DSCR= Net Operating Income / Debt Service
Where,
- Net Operating Income = Total Revenue – All Operating Expenses
- Total Debt Service = Interest + Principal Repayments + Lease Payments
Interpretation
If the DSCR calculated for a company is 1 or more, it indicates that the company can manage the financial obligations from the revenue generated. When the figure equals 1, it shows that the organization earns exactly what it needs to repay its outstanding loans. Hence, having 1 as the DSCR does not allow bearing any additional costs or obligations. As a result, loan approval could be doubtful.
On the other hand, if the same is more than 1, the banks will happily approve loans as they know they will surely get back the lent amount and interest from borrowers. Thus, a DSCR of more than 1 is considered an ideal debt service coverage ratio.
DSCR Calculation Examples
Example 1 (Putting the Formula)
Suppose an investor wants to consider the DSCR of a company before saying yes to investing in it. Here are the details that would be required:
- Revenue =$510 m,
- All Operating Costs = $200 m
- Interest Expense =$60 m,
- Principal Repayments = $35 m.
A. Net Operating Income
Net Operating Income = Revenue – All Operating costs
= $ (510-200) m
= $310 m
B. Total Debt Service
Total Debt Service = Interest + Principal
= $ (60+35) m
= $95 m
C. Let us calculate the ratio using DSCR formula
DSCR= Net Operating Income / Total Debt Service
= 310 / 95
= 3.26
Example 2 (Using Excel)
Let us analyze the debt situation of the offshore drilling services provider, Seadrill Ltd. In 2016, it faced huge problems due to the piling debt and dwindling margins due to persistently low oil prices. As a result, the company reported the following financial numbers in the three quarters mentioned in the table below:
| Items ($ millions) | Description | Q2 2016 | Q1 2016 | Q2 2015 | |
| Depreciation and Amortization | a | Non-Cash Expenses | 193 | 200 | 192 |
| EBITDA | b | Operating Income | 557 | 528 | 615 |
| Interest Expense | c | Interest | 105 | 102 | 100 |
| Current Portion of Long Term Debt | d | Post-Tax Obligations | 2347 | 1278 | 1662 |
| Tax Rate | t | Tax Rate | 27.80% | 27.80% | 10.60% |
Here, the ratio’s denominator will not be the total debt service but the minimum debt service requirement, i.e., the minimum pre-tax amount required to fulfill all the debt obligations (pre-tax plus post-tax).
Since the post-tax obligations are greater than the non-cash expenses, the formula used to calculate the minimum debt service required is written in the Description column in the table below. The formula used is [c+a+(d-a)/(1-t)].
The debt service coverage ratio calculator divides the EBITDA by the value of the minimum debt service requirement. The value of DSCR is much-much less than 1.0. It is expected, given the type of industry Seadrill operates in.
The DSCR drop (31.8 % to 17.0 %) from the second quarter of 2015 to the second quarter of 2016 is drastic. Moreover, it is even steeper (29.4 % to 17.0 %) over the last two sequential quarters (Q1 2016 to Q2 2016). This drastic decline in DSCR is giving a very tough time to Seadrill these days.
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Source: DSCR (Debt Service Coverage Ratio) (wallstreetmojo.com)
Relevance
The relevance of DSCR is mostly observed when the borrowers’ financial strength needs to be assessed. The most common usage is when lenders need to analyze the debt position. Here, the ratio gives a measure of a company’s financial condition with respect to its ability to handle existing debt.
The next wide usage of these ratios is in the banks while they sanction loans. Whenever the lenders have to figure out whether to lend money to companies, it looks at the DSCR but they do not base their decision only on that one factor.
It rather observes the normal trend of the industry and then decides whether to approve a loan for the company. In addition, the bank also considers the historical trend of how the company has been managing its debt obligations to assess its future aspects. If the banking institution finds the company worthy, it agrees to current lending and promises to lend more in the future.
Frequently Asked Questions (FAQs)
Debt service coverage (DSCR) is the ratio between Net Operating Income and Total Debt Service. It helps determine if the company can cover its debts using its net operating income. It is an important metric used during commercial real estate lending as it helps the analysts calculate the amount to lend to companies.
Anything more than 1 is considered an ideal ratio. However, even if the figure arrived at is equal to 1, it might work. This indicates that the company’s revenue is exactly what it needs to repay its debts.
The global debt service coverage ratio is calculated in the same way by dividing the net operating income by the total debt service. Here, the net operating income is obtained by subtracting all net operating expenses from the revenue generated by a company. In contrast, the total debt service is obtained by adding all principal and interest payments of the borrowers.
Recommended Articles
This is a guide to what is DSCR (Debt Service Coverage Ratio) and its meaning. Here we explain its interpretation, relevance, formula, and calculation. You can learn more from the following articles –
- Ratio Analysis
- Types of Financial Ratios
- Financial Ratios
This post first appeared on Free Investment Banking Tutorials |WallStreetMojo, please read the originial post: here
