Debt Coverage Ratio

The debt coverage ratio, also known as the debt service coverage ratio (DSCR), is used for investment property loans and financial statement analysis.

Lenders use the debt coverage ratio primarily to determine whether or not to approve investment property loans.

The debt coverage ratio is used in corporate finance as a measure of a company’s ability to cover its total annual debt service, which includes interest and the current portion of long-term debt obligations paid.

Investment Property Loans

In investment real estate, the debt coverage ratio is the operating income generated by the investment property divided by its total debt service. The total debt service includes both interest and principal payments due annually on the loan.

Calculating the Debt Coverage Ratio for Investment Property Loans

Operating Income/Total Debt Service

Bank lenders use the debt coverage ratio to help them determine whether to make investment property loans or refinance mortgage loans. When a DSCR is greater than 1, it indicates that the debtor has enough net operating income generated from the investment property to cover all his debt obligations. When the debt coverage ratio is less than one, it indicates that net operating income is less than the amount required to service annual debt payments for the property. For example, a debt coverage ratio of 95% indicates the investment property only generates 95% of the income required to meet annual debt payments.

Banks generally require a debt coverage ratio of at least 1.2 for investment property loans or investment property mortgage refinancing as a cushion against default. This means that the property generates 20% more net operating income than the expenses required to service the debt.

For investment property, the net operating income is the income generated from the property less its operating expenses. Operating expenses on investment property include repairs and maintenance, utilities, property insurance, and property taxes. Oftentimes the lender will add vacancy rates (e.g. 5% of the total operating income) and increased maintenance costs to arrive at a more conservative debt coverage ratio.

Debt Coverage Ratio in Investment Property Loans and Mortgage Refinancing Contracts

An investment property loan contract may include a minimum DSCR requirement that must be maintained in order to prevent the loan from going into default.

Financial Statement Analysis and the Debt Coverage Ratio

In corporate finance, the debt coverage ratio is a measure of an entity’s ability to generate enough operating income to cover its total debt obligations. It is calculated by dividing operating income by total debt obligations paid for the year, including principal and interest. This is similar to the interest coverage, except the denominator includes all loan obligations (principal and interest) paid for the period, and not just interest payments.

Calculating the Debt Service Coverage Ratio

Operating Income/interest + prior period current maturities on long-term debt

The sample income statement shows that Sunny paid $1,800 in interest on his loans for the period. The current portion of long-term debt coming due ($1,300 see balance sheet) is paid next year, which is why the prior period current portion of debt is used when calculating the debt coverage ratio for corporate finance. Since Sunny just started his business in 2010, he has no other debt payments to include.

DSCR for Sunny Sunglasses Shop

17,557/1,800 = 9.75

This means that Sunny had 9.75 more operating income than total debt obligations for the 2010 period.

The Debt Service Coverage Ratio According to GAAP

GAAP requires any capitalized lease obligations to also be included in the current portion of maturities when calculating the debt service coverage ratio.

Cash Basis Debt Coverage Ratio

Sometimes the debt coverage ratio is calculated by adding back non-cash expenses such as depreciation and amortization and other non-cash expenses.

Debt Service Coverage Ratio = (Annual Net Income + Amortization + Depreciation + Non Cash Expenses)/Total Debt Service

Though considered a cash basis debt service coverage ratio, it does not take into account that many sales are made on account in the form of accounts receivable. This means that the company may be generating operating income, but not necessarily cash from operations.

To get a true cash basis debt coverage ratio, divide the cash inflows from operations, available on the statement of cash flows, by the total debt service payments made for the same period.

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