The debt service coverage ratio (DSCR) is a method to compares a business’s level of cash flow to its multiple debt obligations including proposed term loan installments. Lenders typically calculate DSCR by dividing the business’s annual net operating income by the business’s annual debt payments. DSCR less than 1 suggests a negative cash flow, and the inability of firm’s profits to serve its debts, whereas a DSCR greater than 1 means the borrower is able to serve the debt obligations
Calculation of DSCR (Debt Service Coverage Ratio):
While sanctioning term loan to a borrower the lender essentially look at the financial papers including funds flow statement of the term loan applicant. The debt service coverage ratio arrived at reflects the net operating income to multiple of debt obligations due within one year, including interest, principal, sinking-fund and lease payments (total debt service).
The formula for finding out debt service coverage ratio (DSCR);
DSCR =(Profit after Tax+ Depreciation+ Interest on Term Loan)÷ (Interest on Term Loan+ Installment amount of Term Loan).i.e. net operating income divided by total debt service.
The acceptable industry norm for a debt service coverage ratio is 1.5 to 2. To have a conclusive idea about the debt serving ability of the borrower, the banks and financial institutions calculate DSCR for the entire period of loan instead of only for one year.
