What is the Debt Service Coverage Ratio?
First, it is helpful to be familiar with how the Debt Service Coverage Ratio is calculated. There are basically two approaches for calculating the Debt Service Coverage Ratio.
The Debt Service Coverage Ratio from the Balance Sheet Method
The balance sheet method is the standard method used in the financial community to calculate debt service coverage ratios. The method is generally seen as the easiest method to calculate. However, there are also some drawbacks to the balance sheet method when it comes to estimating debt service coverage ratios, and investors generally avoid the balance sheet method.
The debt service coverage ratio is calculated in the same manner as a regular business’s taxable income.
What is the formula for calculating the Debt Service Coverage Ratio?
The DSCR represents the minimum required amount of net interest income over the life of the obligation supported by the assets. The calculation of the DSCR is as follows:
Net interest income over interest expense plus NII/average outstanding balances is the denominator.
Deposit liabilities minus deposits of the same maturity is the numerator.
Our adjustment to the numerator is average outstanding balances. If average outstanding balances exceed 100% of minimum required levels, we use the blended average.
Average outstanding balances are the denominator.
Weighting Interest Expense over Interest Income: We weight interest expense over interest income.
When should I use the Debt Service Coverage Ratio?
Understanding your debt service coverage ratio is key to managing your debt. It’s an important benchmark when making decisions about your debt strategy. It’s also a figure the IRS uses in determining your annual taxable income.
Understanding the difference between the Debt Service Coverage Ratio and the Debt to Income Ratio:
The Debt Service Coverage Ratio is the current debt service coverage ratio. It is calculated as follows:
Net Fixed Charge Coverage Ratio = Gross Fixed Charge Coverage Ratio / Equity / Total Equity
So when net fixed charge coverage ratio is greater than 0.80, you have the ability to take the money in your non-interest bearing investments and turn it into cash in a year.
What is a healthy Debt Service Coverage Ratio?
The Debt Service Coverage Ratio is a commonly used tool to measure a utility’s ability to pay debt service on bonds and is generally calculated by dividing total debt service by total operating revenue.
Basically, this ratio shows how many times debt service is paid out each year. A lower number, which is the healthy range, indicates that the company can service its debt efficiently. A higher number, which is the unhealthy range, indicates a company has too many bond payments to service and must put more money into debt service each year to cover those payments.
Simply put, a healthy debt service coverage ratio is good, a lower one is bad, and a higher number is worse.