Debt Service Coverage

Debt service coverage is a common financial metric used to measure an organization's ability to service or repay its long-term indebtedness. Repayments for debt include both interest and principal payments that are amortized over a scheduled period. This metric is typically used to measure the ability an organization has to pay for its principal and interest payments in a given time period. The debt service coverage (DSC)ratio is computed as follows:

Earnings before interest, taxes, depreciation, and amortization (EBITDA) is sometimes referred to as “net revenue available for debt service” and is often defined in loan documents and bond covenants. Annual debt service includes interest payments, principal reductions, and certain lease payments if they are classified as capital leases. The amount of interest paid on debt is correlated to the current principal balance, the time length and frequency of repayments, and the opportunity cost of lending money over the given period (also known as the yield curve).

In short, this calculation provides several important indicators to lenders, creditors, and investors in that it provides insight into the organization's timely repayment of its indebtedness. For example, if the DSC ratio is 2.5, the organization can pay for its indebtedness 2.5 times and the lender or creditor has a margin of safety of 1.5 times above and beyond the repayment of debt.

Fundamentally, this ratio is driven by the ability of a company to generate enough revenue from operations to cover operating costs and the cost to borrow money. All other things kept constant, an increase in revenue will positively affect the debt service coverage ratio. In contrast, fluctuations in operating expenses will inversely affect this ratio. In situations where a company has agreed to variable rates of interest on debt, fluctuations in the interest rate may significantly affect the amount of annual debt service, leaving the ratio at risk from general economic conditions.

If this ratio approaches a level of 1.0, there is an indication that the organization can only meet its debt payments for its current obligations and cannot make other capital expenditures or investments nor could it provide any dividends or distributions to its owners or investors. As such, all stakeholders in an organization typically analyze this critical financial ratio to determine not only the current financial performance of the organization but also its long-term viability and financial performance.

The DSC ratio is most often used in the context of general financial analysis or loan or bond covenants for the organization. Loan and bond covenants are found in the bond legal documents such as a trust indenture or loan agreement, which states the requirements the organization must meet to be in compliance with the loan or bond documents. Often an officer of the organization or its auditor must provide a certificate or letter to the lender or bond trustee as to the accuracy of this ratio.