When it comes to ensuring a business's sound financial management, understanding its ability to manage the existing debt obligations is extremely important. A key metric that helps you understand this is the Debt Service Coverage Ratio (DSCR).
The debt service coverage ratio is an indicator of a business's financial health with respect to its debt obligations and existing cash flow. In the business context, DSCR is used by a company to assess its ability to pay loans and by lenders to measure a business's risk profile for business loan approval.
In this blog post, we will explore the concept of debt coverage service ratio, its importance, and the process of calculating DSCR using its formula.
What is the debt coverage service ratio?
DSCR is a vital financial metric crucial for assessing a company's ability to cover its debt obligations with its operating income. It essentially compares a company's cash flow against its debt, including interest, principal, and lease payments. This ratio is particularly significant in business and real estate finance, acting as a gauge for lenders and investors to assess a firm's credit risk and debt capacity.
The ratio is calculated by dividing the net operating income by the sum of all debt obligations, including the principal and interest. Ideally, a DSCR of greater than 1 indicates that the company has enough cash flow from existing operations to pay off its debt.
On the other hand, a DSCR of less than 1 indicates that the company is not generating enough cash flow to manage its debt. If you're in the market for a business loan, lenders typically consider a DSCR of greater than 1 for the loan application.
What is the use of DSCR?
On a basic level, the debt service coverage ratio helps a business understand its financial health. Depending on the DSCR, a business can decide whether it can raise a loan from the market or issue the sale of bonds. In the latter case, this ratio also helps the company determine the interest rate to be offered on the bond.
In addition, here's how DSCR is used by businesses, investors, as well as lenders-
1. To devise business strategies
Businesses can use their debt service coverage ratio to evaluate their growth potential and seek additional financing to capture growth opportunities. In addition, DSCR is also calculated by analysts in financial forecasting.
2. To determine a company's capital structure
The debt service coverage ratio of a company can also help determine its capital structure, which is a specific mix of debt and equity to fund the business's operations. If the DSCR is too low, the company will have to raise capital through the equity route, which can be costlier.
On the other hand, if the DSCR is too high, the company can issue debt to raise capital. This means a lower cost of raising capital and less dilution of ownership.
3. To make investment decisions
Shareholders and potential investors use DSCR to gauge the financial health of a company and ensure the safety of their investment. It helps determine if the company has enough operating income to fund its growth, pay off its debt, and still have enough left to pay dividends to the shareholders.
4. To check business loan eligibility
When applying for a business loan, lenders and financial institutions use DSCR to determine a company's ability to repay the loan on time. It helps them assess the individual's or business's risk and credit profile to decide whether to move forward with the loan approval.
5. To study a business' performance
DSCR, when analysed together with the liquidity and leverage of a company, can also help understand the financial performance of the business in the long term.
How to calculate DSCR?
The process of calculating DSCR is pretty straightforward, involving two main components: the net operating income and its total debt obligations. The debt service coverage ratio formula is-
DSCR = Net operating income/ Annual debt service,
Where Net operating income = Pre-tax income – operating expenses (rent, wages, taxes, COGS, lease payments, and more in a given year).
However, businesses may also consider EBITDA instead of Net operating income to calculate the DSCR.
Where EBITDA (earnings before interest, tax, depreciation, and amortization) = pre-tax income + interest + depreciation and amortization
On the other hand, the annual debt service includes the total of all the current debts of the company, including all principal and interest in the same period.
For example, the net operating income of a company is Rs. 50,00,000. The company pays an interest of Rs. 10,00,000 on its outstanding loans, and the total principal on debt obligations is Rs. 15,00,000.
So, DSCR = 50,00,000/(10,00,000 + 15,00,000) = 50,00,000/25,00,000 = 2
A debt service coverage ratio of 2 means that the business will still have enough of its operating income even after settling its debt obligations.
How to improve DSCR?
Improving the DSCR requires businesses to either increase their net operating income, reduce their debt obligations, or simultaneously achieve both. Here's how businesses can improve their DSCR-
1. Increase the net operating income: The net operating income can be increased by improving its net profit and sales. This can be achieved by expanding operations, entering new markets, or launching marketing campaigns.
2. Settle existing debts: A business should aim to reduce its debt expenses and pay off the debt on time to reduce its DSCR. Additionally, if the DSCR is too high, it is not ideal to apply for new loans.
3. Cut costs: Lower expenses result in a higher operating income, which means a higher DSCR. Businesses can cut costs by evaluating their operating expenses and minimising redundancies in their processes.
4. Debt refinancing: Businesses with multiple high-interest loans can consider refinancing them into a single loan with a lower interest rate to reduce the overall debt obligation.
Final thoughts
As a business owner, understanding and improving DSCR is crucial for you to ensure financial well-being, attract great investment opportunities, and secure business loans at favourable terms. If it's not quite where it should be, start by evaluating your income and expenses and take necessary measures to improve it.
Looking for a quick business loan? Tata Capital's business loans feature competitive interest rates, flexible repayment terms, minimal paperwork, and faster approval. Scale your operations and take your business to new heights with Tata Capital business loans.
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07 December 2023
6 mins read
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