# Debt Coverage Ratio - Explained

What is Debt Coverage Ratio?

# What is Debt Coverage Ratio?

Debt coverage ratio or debt service coverage ratio is the ratio of net operating income to annual debt service. The annual debt services include interest, principal, sinking fund and lease payments. It is a widely accepted benchmark for measuring an individual or organizations ability to cover the debts payments with its operating income.

## How is Debt Coverage Ratio Used?

The formula for calculating Debt coverage ratio is, Debt Service Ratio = Net operating income / annual debt service. In corporate finance, it is the ratio of available cash flow and current debt obligations. In government finance, it is the ratio of export earning and country's external debts. The Debt service ratio is important in personal finance as well. It is one of the criteria the officers look into before approving income property loans. The net operating income is calculated by subtracting the operating expenses from the company's total revenue. The operating expense does not include the taxes and interest payments. Total debt service is the sum total of interest, principal, sinking fund and lease payments due in the coming year. It may seem complicated to calculate the total debt service as the interest payments are tax deductible, but principal repayments are not. The most accurate formula for calculating total debt service is, Interest+ [Principle/ (1-Tax Rate)] The debt service coverage is important to the lenders and investors to judging a company's creditworthiness. They may compare the figure of different companies before investing in one. The companies also compare the DSR of different years or quarters to evaluate their own performance and gauge the creditworthiness. A DSR value less than 1 indicates the cash flow of the company is not enough for covering all the debt services. Like, if the value 0.8 the company would be able to cover only 80% of their debt services with their net operating income, thus they need to draw money from outside sources to cover their debts. At times the lenders agree to lend money to a borrower with a DSR less than one if they believe the borrower has strong outside resources. The DSR value 1 signifies the company has just enough net operating income to cover its debt services and a minimum decline in net operating income may result in failure of paying the debts. They are considered to be highly vulnerable. Theres no standard minimum limit for getting a loan approved and depends on the lender and macroeconomic condition. In a growing economy, loans are more readily available than in a declining economy. Some lenders may determine a fixed DSR to be maintained by the borrower during the period when the loan is outstanding. Such agreements consider the borrower a defaulter if the borrower fails to maintain the level.

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