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’s have a look at the Debt Coverage Ratio Formula –
By using this formula, we get a clear idea of whether a firm is capable of handling the debt payment regularly or not. If the proportion between the net operating income and the debt payment is too low (like 1 or less), it’s better not to go for debt financing; and for investors, it’s better not to loan the amount to that particular company.
The formula is important to two groups of individuals.
- The first groups of people are those who would like to invest in that particular company. 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 groups of individuals are internal people. They can be from top management, or they can report to the top management. They use this formula to see whether the firm has enough operating income to go for external sources of finance like debt finance.
Also, you may have a look at this detailed post on DSCR
Example of Debt Coverage Ratio Formula
Jaymohan Company has been looking for debt financing. They approached near-by banks and financial institutions. 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?
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The solution lies in debt coverage ratio calculation.
As an accountant, you should first 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 income to cover the debt service cost for the period.
However, the accountant also needs to see whether similar companies under the same industry have similar or closer results. Or the accountant can also check the norm of the industry to be certain that 12.5 is a good proportion.
Before the groups of investors decide to loan the amount of debt to the company, they look at various metrics.
One of the most important metrics is to see whether the company has been earning enough operating income to cover the debt payment. If not, then the investors drop the idea of investment into that particular company.
This ratio may not be the only formula for the investors to check the stability of the company they would like to invest into, but it certainly is one of the most important to ratio to check whether a firm is worthy or not.
Debt Coverage Ratio Calculator
You can use the following Calculator
|Debt Coverage Ratio Formula =||
Calculate Debt Coverage Ratio in Excel
Let us now do the same example above in Excel. This is very simple. You need to provide the two inputs of net operating income and the debt service cost. You can easily calculate the ratio in the template provided.
You can download this template here – Debt Coverage Ratio Excel Template.
Debt Coverage Ratio Formula Video
This has been a guide to debt coverage ratio formula, practical examples, and debt coverage ratio calculator along with excel templates. You may also have a look at these articles below to learn more about Financial Analysis –