Coverage Ratios help evaluate whether a company is secure, solvent and healthy enough to pay its liabilities.
The Debt Service Coverage Ratio(DSCR), also known as Debt Coverage Ratio(DCR) is the ratio of cash available for debt servicing to interest, principal and lease payments. It is a popular standard used in measuring the ability of an entity to produce enough cash to cover its debt payments. The higher the DSCR is, the easier it is to obtain a loan. This phrase can also be treated as a loan condition – a minimum ratio which is acceptable to a lender.
Just an year’s analysis of DSCR does not lead to any concrete conclusion about debt servicing capability. DSCR is relevant only when it is seen for the entire remaining period of a loan.
Calculation of DSCR:
There are two ways to calculate DSCR:
DSCR = EBITDA / (Interest+Principal)
DSCR = (EBITDA – Capex) / (Interest+Principal)
EBITDA = Earnings Before Interest, Tax, Depreciation and Amortization
Principal = The total loan amount of short-term and long-term borrowings
Interest = The interest payable on any borrowings
Capex = Capital Expenditure
EBITDA is used as the equivalent of net operating income.
Interpretation of DSCR:
- DSCR < 1: This indicates a negative cash flow which means you do not have enough income to handle all your debts
- DSCR = 1: This indicates that you have adequate cash to service your debt, but no additional cash in stock
- DSCR > 1: This indicates positive cash flow which implies that you have more income to pay off your debt.
A good DSCR differs from bank to bank. Normally businesses should have a DSCR ratio of
1.5 : 1 which means after repaying 1 lakh, the remaining fifty thousand is reinvested again in the business.
How to improve DSCR?
Before moving on to the methods to improve DSCR, an important point worth mentioning is that you cannot manipulate or artificially inflate DSCR, all that you can do is improve DSCR only when you have a scope to do it.
Methods to improve DSCR:
- Increase Revenue: Debt Service Coverage Ratio
An increase in revenue can be achieved by increasing quantity and selling price which can be accomplished by developing an increase in orders, marketing, advertisement and introducing more superior quality products.
An increase in loan tenor will cause a decrease in instalment each year.
A minor reduction in rate of interest will not cause a change in DSCR. A significant decrease in rate of interest is needed to result in a higher DSCR.
Ballooning effect is an ideal method suitable for new businesses which have low cash flow in initial periods. In these cases, we can adjust the repayment obligations in the initial period so that there is lower instalment for initial periods and increased instalment in later periods. The benefit of this effect is that it generates comfortable DSCR in both initial and later periods.
Importance of DSCR:
The parameters for a good DSCR depend on the competitors, stage of growth and typeof company. For instance, smaller companies at a budding stage will have lower DSCR compared to fully fledged established companies. However, a DSCR below 1.00 indicates that a company is dealing with financial difficulties.
DSCR helps in analysis of projects, businesses and the state of a company.
Finline project report contains the DSCR which is calculated automatically in the report . Anyone without having finance knowledge can create report using Finline