Calculating the Debt Service Coverage Ratio

9/1/2011

By Daniel R. McDonald

The Debt Service Coverage Ratio (DSCR) is a number used to determine if a borrower appears to have the capacity to repay a loan. That may sound simple enough, but in order to generate this ratio you must first understand the numerator and denominator used in the calculation.

The ratio is the cash flow available for debt service (numerator) divided by total debt service (denominator). The denominator is easy. It is the total debt service a borrower has to service, including interest expense, dividends and/or the current portion of long-term debt (debt due in the next twelve months). That calculation is straightforward enough.

The hard part is how to calculate cash flow available for debt service. This gets complicated because there is more than one way to determine this number. One way is to use traditional cash flow. Traditional cash flow or EBITDA (earnings before interest, taxes, depreciation and amortization) is primarily used for income-producing properties (commercial real estate rental properties) and relies on net income of the entity. In this scenario you take the net income (or loss) of the property and add back interest, taxes, depreciation and amortization, to arrive at the available cash flow that can be used to service debt.

The Uniform Credit Analysis cash flow, or UCA cash flow, takes into account the actual changes to cash, from both a balance sheet and income statement standpoint, to arrive at how much cash is available to service debt obligations. This calculation method works well for operating companies relying on cash inflows and outflows, through such items as actual cash collected from sales (changes in accounts receivables), changes in accounts payable and changes to inventories, net sales and cost of goods sold. For commercial and industrial (C&I) credits, the UCA cash flow is more practical and provides more realistic answers on how much cash is available to service debt obligations or Net Cash after Operations (NCAO).

For operating companies, this number actually tells you how much cash is available to service debt, a more realistic outlook when determining if a company will be able to repay its loans.

EBITDA or NCAO is the numerator in the DSCR equation and is used to determine if an entity has the ability to satisfy their obligations. Acceptable industry average level for a DSCR (calculated either way) is at least 1.25x, meaning the borrower has 125 percent of available cash flow to service all of their debt obligations.