The debt service coverage ratio is another financial ratio that provides insight into a company’s financial situation. Expressly, it determines a company’s capability of covering its debt by comparing its debt obligations in relation to its net operating income. Therefore, it assesses the company’s available cash, comparing it with its current principle, cash and sinking fund obligations.
Essentially, this ratio is of great importance for both investors and creditors. Nonetheless, creditors are mostly interested by it. That’s because this ratio determines the firm’s capability of dealing with its debt obligations. Usually, creditors aren’t interested solely in the cash flow and position of a firm. They also want to know the precise amount of money owed, to assess the remaining cash that remains available for paying the future debt.
Distinct from the debt ratio, the debt service coverage ratio factors in all the expenses associated with debt, including interest expense, and others such as sinking fund obligation or pension.
Introducing the Formula of the Debt Service Coverage Ratio
Let’s move our attention towards the formula of this ratio. It is quite simple: so, the debt service ratio = operating income/total debt service costs. The net operating income represents the income or cash flows that remain after the operating expenses have already been covered. In many cases, this is referred to as earnings before interest and taxes or EBIT. As a rule of thumb, you should find this information on the income statement.
On the other hand, the total debt service includes all the costs associated with servicing a firm’s debt. This incorporates principle payments, interest payments, as well as other financial obligations. Bear in mind that the debt service amount is rarely included in financial statements. However, it could be mentioned in the financial statement notes.
Analyzing the Debt Service Coverage Ratio
Furthermore, the debt service coverage ratio determines if a company is financially apt to preserve its existing debt levels. Hence, a higher ratio is much more convenient and favorable than a low ratio. On a different note, a higher ratio displays that there is enough income available for covering the costs of debt servicing.
For instance, if a company has a ratio of 1, this would mean that the firm’s net operating profits equal its debt obligations. Simultaneously, a ratio that is lower than 1 would mean that the firm doesn’t produce sufficient operating profit to pay off its debt service. Therefore, it must consider using part of its savings.
Additionally, for the most part, companies that have higher debt service coverage ratios have more cash. Therefore, they don’t usually encounter any problems when it comes to paying off their obligations on time.
This concludes our introductory article on the debt service coverage ratio. After reading this article, you should understand the reasons why investors and lenders utilize this ratio before making a financial decision. In case you have any additional questions on the topic, we would be happy to address them!