The debt service coverage ratio is a statistic measuring the ability of a business to pay off its debt. This ratio is calculated by taking the amount of net income that is earned by a business in a certain time period and dividing that total by the amount of debt that the business has incurred in that same period. Calculating the debt service coverage ratio, or DSCR, is one way to tell if a business can cover the amount of money it owes in the event that all of its creditors wish to immediately receive payment. A DSCR less than one may indicate financial problems for a business.
It is nearly impossible to grow a business without incurring some debt along the way. Businesses borrow money to help with new initiatives, marketing campaigns, or even day-to-day operations. Strong businesses usually are making enough money along the way to cover that debt and still have something left in reserve. One way of measuring this important relationship between income and debt is the debt service coverage ratio.
As an example, imagine a business that has earned $500,000 US Dollars (USD) over a specific period of time. Over that same period of time, the business has incurred debt, in terms of both the principal it owes to creditors and the interest payments on those same loans, totaling $400,000 USD. To calculate the debt service coverage ratio, the $500,000 USD in income is divided by the $400,000 USD in debt, which yields a DSCR of 1.2.
Generally speaking, a ratio of less than one can be problematic for a business, as it means that it doesn't have enough money to pay off its current debt. It's also dangerous when the debt service coverage ratio continues to drop when studied over a period of time. This can be an indicator that the earnings level is dropping out of proportion with debt or that the business is borrowing more money than it can pay back.
A debt service coverage ratio exceeding one allows a business the luxury of being able to pay off its debts while still having some money left over. This extra amount may be reinvested in the business or saved for emergencies. It's important to note that an extremely high DSCR is not necessarily a positive sign for a business. When this occurs, potential investors may judge that the business is not utilizing its excess income to the fullest extent, which may ultimately harm its growth.
