Debt Service Coverage Ratio

In accounting and finance, debt service coverage ratio measures a company’s ability to repay its debts. It represents the number of times a company’s operating income can pay off the principal and interest payments on its loans and leases. It is calculated by dividing operating income by total debt related payments. A higher ratio is better.

Explanation

While times interest earned ratio measures a company’s ability to repay the interest payments only, debt service coverage ratio also takes into account the related principal repayments and lease payments. Together with debt ratio and times interest earned ratio, it provides useful insight especially when there are significant amount of amortizing loans or leases in the capital structure. EBITDA coverage ratio can approximately serve the objective of debt coverage ratio in many cases.

In economics and personal finance, debt service (coverage) ratio is calculated differently though its basic objective is the same i.e. to measure the ability to repay debts.

Formula

Example

You are analyzing FN, Inc. financial statements for financial year 2014. Following is an extract from the financial statements. All amounts are in million USD.

Calculate debt service coverage ratio.

Solution

Debt service coverage ratio includes operating income in the numerator and debt payments in the denominator.

Let us first calculate the components.

Operating income
= net income + taxes + capital (finance) lease + interest expense on loan
= $45 million + $30 million + $7 million + $13 million
= $95 million

Debt payments
= loan re-payments + total lease payments
= $30 million + $20 million
= $50 million

Debt service coverage ratio = $95 million/$50 million = 1.9

A debt service coverage ratio of 1.9 is pretty good. In fact, a ratio greater than 1 indicates that the company generated profit before interest and taxes that’s more than its obligations under its debts.

by Obaidullah Jan, ACA, CFA and last modified on Nov 1, 2014