Debt Coverage Ratio

What is the Debt Coverage Ratio?

The debt coverage ratio is one of the important solvency ratios and helps the analyst determine if the firm generates sufficient net operating income to service its debt repayment.

Debt Coverage Ratio Formula

Let us look at the debt coverage ratio formula:

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Source: Debt Coverage Ratio (wallstreetmojo.com)

By using this formula, we get a clear idea of whether a firm can handle debt payments regularly or not. If the proportion between the net operating income and the debt payment is too low (like one or less), it is better not to go for debt financing. It is better not to loanLoanA loan is a vehicle for credit in which a lender will give a sum of money to a borrower or borrowing entity in exchange for future repayment.read more the amount to that particular company.

The formula is important to two groups of individuals.

• The first group of people would like to invest in that company. But, before they ever loan the amount to the firm, they want to know whether the firm has enough operating income to cover the payments.
• The second group of individuals is internal people. They can be from top management or report to the top management. They use this formula to see whether the firm has enough operating income to go for external sources of financeExternal Sources Of FinanceAn external source of finance is the one where the finance comes from outside the organization and is generally bifurcated into different categories where first is long-term, being shares, debentures, grants, bank loans; second is short term, being leasing, hire purchase; and the short-term, including bank overdraft, debt factoring.read more like debt finance.

Also, you may have a look at this detailed post on DSCRDSCRDebt service coverage (DSCR) is the ratio of net operating income to total debt service that determines whether a company's net income is sufficient to cover its debt obligations. It is used to calculate the loanable amount to a corporation during commercial real estate lending.read more

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Debt Coverage Ratio Formula in Video

Example of Debt Coverage Ratio Formula

Jaymohan Company has been looking for debt financing. They approached nearby banks and financial institutionsFinancial InstitutionsFinancial institutions refer to those organizations which provide business services and products related to financial or monetary transactions to their clients. Some of these are banks, NBFCs, investment companies, brokerage firms, insurance companies and trust corporations. read more. Jaymohan Company has found out that the debt service cost would be around $40,000 for a particular period. They want to know whether their net operating income is enough to cover the expenses. You are the accountant of Jaymohan Company, and you found out that the operating income for this particular period is $500,000. Would you think that Jaymohan Company should go for debt financing after all?

The solution lies in debt coverage ratio calculation.

An accountant should see the proportion between the net operating income and the debt service cost.

• Formula = Net Operating Income / Debt Service Cost
• = $500,000 / $40,000 = 12.5.

As per the ratio is concerned, Jaymohan Company has enough net operating incomeNet Operating IncomeNet Operating Income (NOI) is a measure of profitability representing the amount earned from its core operations by deducting operating expenses from operating revenue. It excludes non-operating costs such as loss on sale of a capital asset, interest, tax expenses.read more to cover the debt service cost for the period.

However, the accountant also needs to see whether similar companies in the same industry have identical or closer results. Or the accountant can also check the industry’s norm to be certain that 12.5 is a good proportion.

Uses

Before the investors decide to loan the company’s debt, they look at various metrics.

One of the most important metrics is whether the company has earned enough operating income to cover the debt payment. If not, the investors drop the idea of investing in that company.

This ratio may not be the only formula for the investors to check the company’s stability they would like to invest in. Still, it certainly is one of the most important ratios to check whether a firm is worthy or not.

Debt Coverage Ratio Calculator 

You can use the following calculator:

Calculate Debt Coverage Ratio in Excel 

Let us now do the same example above in Excel. It is very simple. You must provide the inputs of net operating income and debt service cost. Then, you can easily calculate the ratio in the template provided.

You can download this template here – Debt Coverage Ratio Excel Template.

Frequently Asked Questions (FAQs)

Recommended Articles:

This article is a guide to the Debt Coverage Ratio. We discuss the debt coverage ratio formula, practical examples, a calculator, and Excel templates. You may also look at these articles below to learn more about financial analysis: –

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