Three Uses of the Debt Service Coverage Ratio: Investment Property Loans, Home Mortgages, and Corporate FinanceLenders use the DSCR primarily to determine whether or not to approve investment property mortgage loans. The DSCR is also used for approving residential lending for home mortgages and mortgage refinancing. Finally, the DSCR 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. Commercial Real EstateInvestment Property Mortgage LoansIn investment real estate, the debt service 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 on the loan. Banks use the DSCR to help 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 income generated from the investment property to cover all his debt obligations. Banks generally require a DSCR of at least one for personal finance home mortgages or home mortgage refinancing, and 1.2 for investment property mortgage loans or investment property mortgage refinancing. 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 DSCR ratio.
Residential LendingFor home mortgages, the debt service coverage ratio is calculated by taking the income and expenses of the borrower. Corporate FinanceIn corporate finance the debt service 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, including principal and interest. This is similar to the interest coverage ratio, 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 The sample income statement shows that Sunny paid $1,800 in interest on his loans for the period. Only interest expense for the period is shown on the income statement, and not current portions of debt. Notice under current liabilities on the balance sheet in the examples of balance sheets section that the current portion of long-term debt coming due on the mortgage for land is $900, and the current portion coming due for the note payable on the company vehicle is $400. Since this amount was not paid yet, it is not included in the debt service coverage ratio. The amount that is paid is the amount coming due in the prior period, which in this case was zero for Sunny Sunglasses Shop since he had just started his business. The current portion of long-term debt due is paid next year, which is why the prior period current portion of debt is used when calculating the debt service coverage ratio for entities.
This means that Sunny has 9.75 more operating income than total debt obligations for the period. DSCR according to GAAP Sometimes the debt service coverage ratio is calculated by adding back non-cash expenses such as depreciation and amortization and other non-cash expenses. DSCR = Annual Net Income + Amortization/Depreciation + other non-cash expenses/Total Debt Service. Though considered a cash basis DSCR, it does not take into account that many sales are made on account in the form of accounts receivable, or that many expenses are paid on account in accounts payable. This means that the company may be generating operating income, but not necessarily cash from operations, and may be paying expenses, but not using cash. To get a true cash basis DSCR, or cash available to cover total debt obligations for the period, the cash inflows from operations, available on the statement of cash flows, is divided by the total debt service for the same period. A DSCR of less than one means that there is not enough operating income (or cash for cash calculations) to cover the debt service. For example, a DSCR of .95 means that the net operating income can only cover 95% of the total debt obligations. A lender generally would want a ratio higher than 1.2 for investment property mortgage loans or to refinance investment property. A DSCR over one means that the company generates enough income to cover all of its debt obligations. The higher the ratio, the more income a company has available to cover its debt obligations. Back from the debt service coverage ratio to the Financial Ratios Main Page Back to the Accounting Terms Main Page Back to the GAAP Small Business Accounting Home Page
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