Debt coverage ratio is a measurement of a company ability to meet its debt obligations from its cash flow. In other words, it’s measure the company ability to generate enough income with its operations to cover its debt obligations. The ratio is a representative of net operating income as a multiple of debt obligations due within one year. The debt obligations (might be any borrowings on its balance sheet like loans and bonds) include: interests, principle, and lease payments. The debt coverage ratio is used to analyse companies, usually by lenders, to estimate the company ability to meet its debt obligations. The minimum ratio a lender will look for in a business depends on its risk tolerance and thee current macroeconomic conditions.
The formula for calculating debt coverage ration requires net operating income and total debt services on the company.
Debt Coverage Ratio = Net Operating Income / Total Debt Services
The Net operating income is derived from company total revenue minus its operating expenses (excluding taxes and interest) or EBIT. Total debt is the all the current debt obligations (interest and principle) for the given period, usually one year.
A company that has operating net income of $700,000 and debt service cost of $50,000 for the given period will have debt coverage ratio of: Net Operating Income/ Total Debt Services = $700,000 / $50,000 = 14
The debt coverage ratio can be used internally by the company management itself in order to assess its own ability to cover debt payments and obligations. It can also be used by lenders or investors to estimate company financial health and growth and borrowing potential. Companies with higher ratios are considered by investors and lending institutions to be more financially stable. We have to keep in mid the the ratio can change dramatically as the business takes on new debt, pays off old debt, or experiences revenue fluctuations.
If a debt the coverage ratio of a business is too close to 1 it is a sign of risk and vulnerability. This means that only a slight decrease in cash flow and the company will not be able to meet its debt obligations. The minimum DSCR that a lender will require depends of a variety of factors like lenders risk tolerance, current economic condition and the predictability of the business. If the general economy is growing, credit is more available, and the business in question is growing and in a predictable stable industry, lenders may be more tolerant of lower ratios.