30 May, 2025
4 mins read
When businesses apply for a loan, lenders often ask a critical question: Can this company repay its debt comfortably? That’s where the Debt Service Coverage Ratio (DSCR) comes into play. It’s a financial metric that helps both businesses and lenders assess the ability to meet debt obligations without strain.
In this article, we’ll explore what is Debt Service Coverage Ratio is, how it’s calculated, its importance, and how it can be improved.
So, what is DSCR exactly?
The Debt Service Coverage Ratio (DSCR) is a financial measure used to determine a company’s ability to service its debt, meaning whether it has enough income to cover its interest and principal payments. In simpler terms, it answers the question: "Does the business earn enough to pay off its debts?"
A DSCR greater than 1 means the company generates more income than it needs to meet debt obligations. A ratio below 1, however, signals potential trouble, as the income is insufficient to cover debts.
Understanding DSCR is crucial for several reasons:
For lenders, it helps evaluate the creditworthiness of a borrower. A high DSCR indicates a lower risk of default.
For business owners, it shows how well the company can handle its existing financial commitments.
For investors, it provides insights into the company’s financial health and operational efficiency.
Whether you're applying for a business loan or assessing financial performance, knowing your DSCR can influence critical decisions.
The DSCR formula is fairly straightforward:
|
DSCR = Net Operating Income / Total Debt Service |
Where:
Net Operating Income (NOI) is the income left after operating expenses are deducted from revenue. It is also called Earnings Before Interest and Taxes.
Total Debt Service includes all principal and interest payments on debt for a given period.
This ratio gives a clear picture of how much of the company's income goes into debt repayment.
Now let’s walk through how to calculate the Debt Service Coverage Ratio step by step:
Find the Net Operating Income (NOI)
Start with total revenue.
Subtract operating expenses (excluding interest and tax).
This gives you the Net Operating Income.
Determine Total Debt Service
Add all interest payments and scheduled principal repayments for the same period.
Apply the DSCR Formula
Divide NOI by Total Debt Service.
Let’s take a Debt Service Coverage Ratio example to make it even clearer.
Imagine ABC Ltd. has the following figures for the financial year:
Revenue: ₹50,00,000
Operating Expenses: ₹30,00,000
Interest on Loan: ₹3,00,000
Principal Repayment: ₹5,00,000
Step 1: Calculate Net Operating Income (NOI)
Revenue - Operating Expenses = ₹50,00,000 – ₹30,00,000 = ₹20,00,000
Step 2: Calculate Total Debt Service
Interest + Principal = ₹3,00,000 + ₹5,00,000 = ₹8,00,000
Step 3: Apply DSCR Formula
DSCR = ₹20,00,000 / ₹8,00,000 = 2.5
Conclusion: ABC Ltd. earns 2.5 times what it needs to service its debt, which is excellent.
If your DSCR is below the ideal DSCR ratio, here are some ways to improve it:
Increase operating income: Boosting sales or reducing operating costs can help increase NOI.
Reduce debt obligations: Consider refinancing or restructuring loans to lower interest rates or extend repayment periods.
Delay unnecessary expenses: Temporarily cutting non-essential spending can improve cash flow.
Inject equity: Infusing additional capital from investors or owners can strengthen finances.
Improving DSCR not only enhances creditworthiness but also brings stability to the business.
While DSCR is useful, it’s not without its limitations:
It doesn't reflect cash flow timing: A business may have a good DSCR annually but struggle with monthly cash flow.
May not account for non-operating income: Some businesses may rely on irregular income, which isn’t captured in NOI.
Industry differences: A “good” DSCR in one industry may be too low in another.
It’s backward-looking: It only reflects past performance, not future potential.
So, while it’s a valuable indicator, DSCR should be considered alongside other financial metrics.
To sum it all up, the Debt Service Coverage Ratio is a key financial metric that helps determine a business’s ability to pay off its debts. Whether you're a lender, investor, or business owner, understanding what the DSCR is, how to calculate the Debt Service Coverage Ratio, and how to interpret it is essential for making informed financial decisions.
From understanding the DSCR formula to analysing an example, you now have the tools to assess your business's financial health and make improvements where needed.
An ideal DSCR ratio is generally considered to be 1.25 or higher. This means the company earns 25% more than it needs to cover its debt obligations, giving a cushion for unforeseen circumstances.
Yes, DSCR can be negative if the company’s net operating income is negative or significantly lower than its debt obligations. This is a red flag for lenders, indicating poor financial health or excessive debt.
DSCR is calculated using the formula:
DSCR = Net Operating Income / Total Debt Service
It shows how well a company can pay off its debt from operating income.
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