What is the Debt Service Coverage Ratio (DSCR)?
Debt service coverage (DSCR) is the ratio between Net Operating Income and Total Debt Service and helps in determining whether the company is capable of covering its debt obligations with the net income it generates. It is an important metric used during commercial real estate lending that helps the analyst in calculating the amount loanable to the company.
It can be expressed mathematically as follows:
DSCR = Net Operating Income/Total Debt Service
This ratio gives an idea of whether the company is capable of covering its debt-related obligations with the net operating income it generates. 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. On the other hand, if this ratio is more than one for a company, it means that the company is generating enough operating income to cover all its debt-related obligations.
Calculating Net Operating Income
Debt Service Coverage Ratio is a ratio of two values: Net Operating Income and Total Debt Service.
Operating Income is defined as earnings before interest and tax (EBIT). However, for this purpose, the Net Operating Income is taken as the Earnings Before Interest, Tax, Depreciation, and Amortization (EBITDA). Hence, the formula for calculating the Net Operating Income will be as follows:
Net Operating Income = Net Income + Interest + Non cash Expense + Tax
The tax amount is added back to the net income while calculating the net operating income because interest payment comes prior to tax payers for the company (even on the income statement). So, the cash in hand before interest payment will first be used to pay the interest and then only to pay the tax.
And depreciation and amortization are non-cash expenses. So they don’t imply any cash outflow, which means that much cash is still in the hands of the company to service its debt obligations. That is why that entire amount is added back to the net income while calculating the net operating income.
Calculation of Total Debt Service
Now, something more complicated to calculate is the denominator of the Debt Service Coverage Ratio ratio i.e., the Total Debt Service. For calculating the value of this term, you got to take into account both the interesting part as well as the principal part of the debt to be serviced.
Total Debt Service = Interest + Principal Repayments + Lease Payments
Note that in addition to the principal, there could be other obligations, too, like Lease Payments and the Current Portion of Long Term Debt.
Let us now take a very basic example on DSCR Calculations.
DSCR Ratio Examples
Example 1
Suppose a company by the name of ABC Ltd. has the following financial figures for a particular period under consideration:
- Net Income=$ 490 million,
- Interest Expense =$ 50 million,
- Non-cash Expenses=$ 40 million,
- Tax rate=30 %,
- Principal Repayments = $ 20 million.
- Lease Repayments = $5 million
Calculate DSCR?
Let us first calculate the Net Operating Income.
Net Operating Income = Net Income + Interest + Non cash Expense + Tax
Tax = $ 490 million x (30 %/70%) =$ 210 million.
Net Operating Income = $ 490 million + $ 50 million + $ 40 million + $ 210 million = $ 790 million
Total Debt Service = Interest + Principal + Lease Payments
Total Debt Service = 50 + $20 + $5 = $ 75 million
DSCR = Net Operating Income/Total Debt Service = $ 790 million/$ 75 million = 10.53x
This DSCR Ratio is greater than 1. Hence, the company ABC has 10.53 times the cash it required to service all its debt obligations for the period under consideration.
Now that you are well versed with the basic DSCR Calculations let us now make some tweaks in the above formula to correctly calculate DSCR.
Example 2
Let us again take the above example and let me modify this a bit.
- Net Income=$ 490 million,
- Interest Expense =$ 50 million,
- Non-cash Expenses=$ 40 million,
- Tax rate=30 %,
- Principal Repayments = $ 200 million.
- Lease payments = $5 million
Calculate DSCR?
What’s the difference between this example and the earlier one that we considered.
In this example, we note that principal repayments are $200 million and Lease payments of $5 million = $205 million.
The important point to note here is that the sum total of Principal Repayment and Lease payments ($200 + $5 = $205) is more than Non-Cash Expenses of $40 million.
Now just pause for a moment. Think! I mean, really THINK!
In the first example, the Non-cash expense of $40 million was enough to take care of obligations, including Principal repayment of $20 million and Lease Payments of $5 million. But NOT in the second example.
The non-cash expense only covers $40 million of the $205 required.
How will the company pay the remaining $205 – $40 = $165 million? Where will the $165 million come from?
The company should have cash of $165 million in its balance sheet to ensure such payments. Obviously, the company needs to earn post-tax cash of $165 million.
Keyword – Post-tax cash of $165 million.
Now, look at the DSCR formula again,
DSCR Formula = Net Operating Income/Total Debt Service
The numerator i.e., Net Operating income, is a “Pre-tax number”.
In order to make the formula fully correct, we need the denominator to be also a pre-tax level.
It is important to realize that unlike the interest the balance portion of principal and lease, repayments 5 million is paid out of the cash remaining on the company’s balance sheet after the deduction of tax.
For calculating the pre-tax number, we need to divide the balance amount of $165 million by (1-tax rate).
In example 2, the balance required is $165 million,
Pre-tax requirement = $165 / (1-.3) = 235.71 million.
With this above pre-tax requirement, we can now correctly calculate DSCR.
Net Operating Income = Net Income + Interest + Non cash Expense + Tax
Tax = $ 490 million x (30 %/70%) =$ 210 million.
Net Operating Income = $ 490 million + $ 50 million + $ 40 million + $ 210 million = $ 790 million
Please note that now there is a change in the Total Debt Service Formula.
Total Debt Service = $50 + $235.71 (calculated above)
Total Debt Service = 285.71
This method of recalculating the Total Debt Service is called as “Pre tax provision Method.”
DSCR Formula = Net Operating Income/Total Debt Service
= $790 / $285.71 = 2.76x.
Considering only the Total Debt Service will be meaningless because the tax is a reality that every company has to face. So the amount calculated by considering the tax deduction as explained above is a more appropriate representative of the Total Debt Service that a company needs to cover by using the EBITDA it generates.
DSCR Ratio for analyzing the debt position
- The value of the DSCR Ratio gives a measure of a company’s financial condition since it evaluates the company’s ability to service existing debt. So, if we have these values for a company and its competitors, we can do a comparative analysis for those companies.
- Also, this ratio is used by creditors to evaluate whether to extend additional financing to a company or not.
- Since DSCR includes the interest as well as the principal payments on the outstanding debt, it gives a better idea about a company’s ability to service debt than do the other debt-related ratios like the interest coverage ratio.
- However, it must be kept in mind that when this Ratio is to be used for comparing a set of companies, the companies must be similar or at least belong to the same or similar industry or sector.
- It is because industries that require huge capital expenditures in their normal business usually have DSCR Ratio below 1.0 or 100 %.
- The companies that belong to such a sector are almost never able to pay out all of their current debt liabilities before adding more debt to their balance sheet.
- So they generally try to get their debt maturity dates extended and seldom generate enough net operating income to be able to service all the interest and principal due for a particular period.
- For example, mining companies and oil & gas exploration, production, and service companies often have DSCR values less than 1.0.
- From the investors’ point of view, one more point of importance is that the company should not have an unnecessarily high DSCR or Debt Service Coverage Ratio.
- It should maintain near about the DSCR norm of the industry or that its creditors demand. It is because a very high value in comparison to the required one would mean that the company is not putting the cash on hand to any good use.
- It makes investors cast doubts on the company’s future prospects, and they may not want to put their money on such stock.
Calculate Debt Service Coverage Ratio of Seadrill Ltd
Take, for example, the debt situation of the offshore drilling services provider, Seadrill Ltd. It is facing huge problems this year due to the piling debt and dwindling margins due to persistently low oil prices. The company has 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% |
The above table shows the company’s financial numbers for Q2 2015, Q1 2015, and Q2 2016. Depreciation and amortization comprise the non-cash expenses, and the current portion of long-term debt comprises the post-tax obligations. The “total debt service” can be calculated as the sum of interest expense and the current portion of long-term debt. But that is not what we need to calculate while calculating an appropriate DSCR Ratio.
What is required to be used as the denominator of the ratio is the “Minimum debt service requirement,” i.e., that minimum pre-tax amount that is required to fulfill all the debt obligations (pre-tax plus post-tax).
Now, since the post-tax obligations are greater than the non-cash expenses, the formula used to calculate the minimum debt service required is the one written in the “Description” column against item “e” in the table above. The formula to be used is [c+a+(d-a)/(1-t)].
Once this value is calculated, the Debt Service Coverage Ratio has been calculated by dividing the EBITDA by this value of minimum debt service requirement. The value of DSCR is much-much less than 1.0. It is expected, given the type of the industry Seadrill operates in.
However, look at the drastic drop (31.8 % to 17.0 %) in the DSCR of the company from the second quarter of 2015 to the second quarter of 2016. In fact, the drop is 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.
How banks use DSCR to lend money?
- As noted from the above example of Seadrill Ltd, whenever a bank has to analyze whether to lend money to such companies, it won’t ask for a DSCR of 1.0 or more.
- It would rather see the industry norm for the ratio and then decide upon the case of the company. In addition to this, the bank would also study the historical trend of the company’s debt serving capacity and future aspects.
- After that, if it finds the future aspects promising enough, it can agree to lend more to the company.
- Also, extending the loan term or the maturity date can also improve the DSCR because, by doing so, the denominator i.e., the debt required to be served within a particular period, gets reduced!
- On the other hand, if the bank finds out that the company does not have an alright debt service history or even that the company is quite new to taking debt, it will require a much higher value of the Debt Service Coverage Ratio. It is because there is a greater risk in lending to such ill-experienced or inexperienced companies.
Conclusion
We note in this article that Debt Service Coverage Ratio is one of the most important ratios tracked by banks, financial institutions, and lenders. This ratio gives an idea of whether the company is capable of covering its debt-related obligations with the net operating income it generates. If the DSCR ratio is less than 1.0x, then it cast doubts on the debt repaying capabilities of the company. Also, note the correct usage of the DSCR formula using the Pre-tax provision method.
If the amount of the post-tax obligations is less than the non-cash expenses then, We do not need to do any adjustments in the Total Debt Service (example 1).
Total Debt Service = Interest + Principal Repayments + Lease Payments
But if post-tax obligation exceeds the non-cash expenses, then the non-cash expense can only partly be covered, and the company needs to save enough cash before tax for covering the remaining part after deducting the tax. (example 2).
Total Debt Service = Interest + Non Cash Expense + (Principal Repayment + Lease Repayment – Non Cash Expense) / (1-tax rate).
So, whatever be the situation, out of the two mentioned above, the amount calculated by the above formulas will give you the amount of cash required to cover the Total Debt Service.
DSCR Video
Other articles that you may find interesting
Syed Zafarul Hasan says
Found very informative and practical.
Dheeraj Vaidya says
thanks Syed!