Debt Service Coverage Ratio (DSCR)
A debt service coverage ratio is also known as a debt coverage ratio, and is the ratio of cash available compared to the debt servicing to interest. Investors use a debt service coverage ratio or debt coverage ratio as a basic quantitative method to see if a company handle the amount of debt it has. In personal finance it can be used by bank loan officers as part of the picture to determine the ability to service debt like a mortgage.
The higher the ratio, the better and easier it will be to obtain further loans. If a ratio drops too low it is possible a company can breach a DSCR covenant and be considered an act of default. This is defensive measure put in the contracts of the debt.
Debt Service Coverage Ratio is really a simple concept, you compare your Net Income to your Debt Service, which is the interest payments or debt related charges in a year.
For a company you have to add back non cash charges like amortization or depreciation, and stock options before making the comparison.
How to Calculate: Debt Service Coverage Ratio
Net Operating Income = (Annual Net Income + Amortization/Depreciation + Interest Expense + other non-cash items (like stock options)
Debt Service = (Principal Repayment + Interest Payments + Lease Payments)
What does the calculation mean?
A DSCR of less than 1 indicates a negative cash flow company which means there is inadequate coverage. If a company has a .90 DSCR, that means there is only enough net operating income to cover 90% of the annual debt payments.
While a DSCR of 1 indicates a company can service it’s debt, it is wise to require a buffer above 1.
What does Debt Service Coverage Ratio mean For Stocks?
When investing in leveraged or in companies with significant debt it is extremely important to consider it’s ability to service it’s debt and any covenants that can be breached by a DSCR declining to too low of a level. Bankruptcy can be devastating for common stock holders.
What does Debt Service Coverage Ratio mean For Bonds?
If a company has an inadequate DSCR then bankruptcy could be imminent and then a bond holder must consider his position in senior and the capital structure of the company and his effective return in a recovery.
How do I calculate DSCR for a company?
Example: Charter Communications (September 2014)
We will use EBITDA as a proxy for (Annual Net Income + Amortization/Depreciation + Interest Expense + other non-cash items (like stock options)
Because According to Charter’s most recent financial filing:
Adjusted EBITDA generally correlates to the leverage ratio calculation under the Company’s credit facilities
Charter has posted an EBITDA of $2,345 million through 9 months ending September 2014. We will extrapolate their 3rd Quarter EBITDA to 4th Quarter for simplicity for a total of Estimated EBITDA of $3,128 million for FY 2014. We will also do the same for their Interest Payments and add $217 million of interest expense to the $638 million YTD through September 2014 for a total of $855 million for FY 2014.
Debt Service Coverage Ratio = $3,128 million (Net Operating Income) / $855 million (Debt Service) = Healthy Ratio of 3.66
The ratio for a company must be at least 1 for it to handle it’s debt, and usually much higher to handle the future maturity. Special care must be paid to when a companies debt reaches maturity for repayment in addition to any interest expenses.
Some companies and industries are more forgiving to debt then others. Real Estate and Cable have been prime examples of where leverage is more welcomed since cash flows tend to be more easily extrapolated into the future then in some other businesses.