The debt service coverage ratio, also known as "debt coverage ratio," is the ratio of
cash available for debt servicing to interest, principal and lease payments. It is a popular
benchmark used in the measurement of an entity's ability to produce enough cash to cover its
debt payments. The higher this ratio is, the easier it is to obtain a loan. The phrase
is also used in commercial banking and may be expressed as a minimum ratio that is acceptable
to a lender; it may be a loan condition. Breaching a DSCR covenant can, in some circumstances,
be an act of default.
Uses In corporate finance, DSCR refers to the amount
of cash flow available to meet annual interest and principal payments on debt, including
sinking fund payments. 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, but more aggressive banks would accept
lower ratios, a risky practice that contributed to the Financial crisis of 2007–2010. A
DSCR over 1 means that 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
is commonly used to ensure that loan repayment can be met even in periods with DSCR<1.0
Calculation In general, it is calculated by: DSCR =) / To
calculate an entity’s debt coverage ratio, you first need to determine the entity’s
net operating income. To do this you must take the entity’s total income and deduct
any vacancy amounts and all operating expenses. Then take the net operating income and divide
it by the property’s annual debt service, which is the total amount of all interest
and principal paid on all of the property’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’s operating expenses. 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.
Typically, most commercial banks require the ratio of 1.15 - 1.35 times to ensure cash
flow sufficient to cover loan payments is available on an ongoing basis.
Example Let’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 of a portfolio of
mortgages. For example, on June 19, 2008, a popular US rating agency, Standard & Poors,
reported that it lowered its credit rating on several classes of pooled commercial mortgage
pass-through certificates originally issued by Bank of America. The rating agency stated
in a press release that it had lowered the credit ratings of four certificates in the
Bank of America Commercial Mortgage Inc. 2005-1 series, stating that the downgrades "reflect
the credit deterioration of the pool". They further go on to state that this downgrade
resulted from the fact that eight specific loans in the pool have a debt service coverage
below 1.0x, or below one times. The Debt Service Ratio, or debt service coverage,
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 $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, since no one would make a loan like this initially,
a financial analyst or informed investor will seek information on what the rate of deterioration
of the DSC has been. You want to know not just what the DSC is at a particular point
in time, but also how much it has changed from when the loan was last evaluated. The
S&P press release tells us this. It indicates that of the eight loans which are "underwater",
they have an average balance of $10.1 million, and an average decline in DSC of 38% since
the loans were issued. And there is still more. Since there are a
total of 135 loans in the pool, and only eight of them are underwater, with a DSC of less
than 1, the obvious question is: what is the total DSC of the entire pool of 135 loans?
The Standard and Poors press release provides this number, indicating that the weighted
average DSC for the entire pool is 1.76x, or 1.76 times. Again, this is just a snapshot
now. The key question that DSC can help you answer, is this better or worse, from when
all the loans in the pool were first made? The S&P press release provides this also,
explaining that the original weighted average DSC for the entire pool of 135 loans was 1.66x,
or 1.66 times. In this way, the DSC ratio provides a way
to assess the financial quality, and the associated risk level, of this pool of loans, and shows
the surprising result that despite some loans experiencing DSC below 1, the overall DSC
of the entire pool has improved, from 1.66 times to 1.76 times. This is pretty much what
a good loan portfolio should look like, with DSC improving over time, as the loans are
paid down, and a small percentage, in this case 6%, experiencing DSC ratios below one
times, suggesting that for these loans, there may be trouble ahead.
And of course, just because the DSCR is less than 1 for some loans, this does not necessarily
mean they will default. Pre-Tax Provision Method
Income taxes present a special problem to DSCR calculation and interpretation, because
one component of debt service is a tax-deductible expense but another component of debt service
is not an expense and does not impact taxable income. While Earnings Before Interest, Taxes,
Depreciation and Amortization is an appropriate indicator of a company's ability to make its
interest payments, EBIDA is a more appropriate indicator of a company's ability to make its
required principal payments. The Pre-Tax Provision Method offers a solution to calculate a meaningful
single ratio that expresses debt service capacity in spite of these challenges.
Debt Service Coverage Ratio as calculated using the Pre-Tax Provision Method answers
the following question: How many times greater is the company's EBITDA than its critical
EBITDA value, where a company's critical EBITDA value is that which just covers its Interest
oglibations + Principal oglibations + Unavoidable income taxes + Other necessary expenditures
not treated as accounting expenses, like dividends and CAPEX.
The DSCR calculation under the Pre-Tax Provision Method is EBITDA /, where Pre-tax Provision
for Post-tax Outlays is simply the amount of pretax cash that must be set aside to meet
required post-tax outlays, i.e., CPLTD + Unfinanced CAPEX + Dividends. The provision can be calculated
as follows: If noncash expenses > post-tax outlays, then
Pretax provision for post-tax outlays = Post-tax outlays
For example, if a company’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. If post-tax outlays > noncash expenses, then
Pretax provision for post-tax outlays = Noncash expenses + /
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
to meet the remaining $50M of post-tax outlays. This company’s pretax provision for post-tax
outlays = $50M + $77M = $127M. See also
LLCR Project Finance
References ^ a b c DSCR finance term by the Free Online
Dictionary ^ Corality Debt Service Coverage Ratio Tutorial
^ Debt-Service Coverage Ratio on Investopedia ^ Andrukonis, David. "Pitfalls in ConventionalEarnings-Based
DSCR Measures — and a Recommended Alternative". The RMA Journal.
¶ Free Video Tutorial Explaining The Concept Of Debt Service Coverage Ratio And Other Coverage
Ratios In Plain Jargon Free English