Debt financing or taking loans can help stretch your financial capability beyond the limitation of your available assets. Having access to affordable loans, whether for companies or individuals, is essential for economic success. However, positive debt leveraging also requires borrowers to maintain financial discipline, which brings us to the concept of the Debt Service Coverage Ratio.
This article discusses everything about DSCR, which can help you understand how lenders assess borrowers and how much debt is healthy. Stay with us.
What Is Debt Financing?
It is a key concept in corporate finance that involves raising short-term or long-term capital by borrowing money from lenders.
For example, a company is planning to purchase new machinery, which costs around ₹50 lakh, to increase its production capacity. Movable and immovable assets, including cash reserves, the company has assets worth ₹2 crore. It has two options to finance the cost of the machinery:
- Liquidating a portion of the ₹2 crore and making a cash payment for the purchase.
- Borrowing ₹50 lakh from banks, financial institutions, or other lenders and financing the machinery purchase with the borrowed money.
The second option is debt financing. Any debt financing comes with contractual service obligations for the debt in pre-scheduled intervals. Debt servicing includes:
- Periodic interest payments
- Partly repayment of the principal amount in every period
- Other charges and penalties if contractual obligations are not met in time
This example is from the world of corporate finance, but the concept equally applies to personal finance like consumer durables purchase decisions, car loans, leveraged share market investments, etc.
Advantages of Debt Financing
Many small companies and individuals hesitate to finance business initiatives through debts or make purchases through loans. They feel it could cause unnecessary hassles if they cannot service the loan. However, loans can be productive for personal and business success. Some of the key benefits of debt financing are:
- Relief from asset liquidation
- Interest payment as tax-deductible
- Increased return on investment through leverage
- Increased liquidity through improved creditworthiness
Relief from asset liquidation
Without the option of debt financing, you might need to liquidate or sell off your existing assets, like company ownership, to raise the funds needed to finance your purchase decisions. This might cause a lowering of your ownership control in business, distressed sale of assets, or less than expected ROI(Return on Investment).
Interest payment as tax-deductible
In business taxation, interest payment on debts is tax deductible. It means we deduct interest paid on business loans from the annual earnings before calculating tax. So, debt financing can directly reduce your tax burden. Non-salaried individual entrepreneurs can also claim this benefit.
Increased return on investment through leverage
Debt financing, when managed correctly, can increase your return on investment from equity capital.
For example,
- You have invested ₹100 rupee cash in a business. If the business gives a 5% ROI annually, then you gain ₹5 after a year.
- Now, along with your equity investment of ₹100, you borrow ₹100 more.
- Your total available business capital will be {₹100 (equity investment) +₹100 (debt capital)} = ₹200.
- At the same RoI of 5%, your annual gain will be ₹10 from the equity investment of ₹100.
Increased liquidity through improved creditworthiness
Both in business and personal finance, we may require extra liquidity or funds to keep things operational, meet sudden monetary liabilities, or increase capacities. A positive credit history of taking loans and repaying loans timely can improve your creditworthiness. It opens up access to affordable loans, improving business and personal liquidity.
What Is Debt Servicing?
Debt servicing is the contractual liability of a borrower for paying interest and a part of the principal due in every period as per the loan agreement. For servicing a debt successfully, the borrower must have the fund or flow of income to make these periodic payments timely.
Timely debt servicing improves the creditworthiness of borrowers. If a borrower cannot service debts or loans, it may lead to disruptions, like hassles caused by collection agents, court cases, and insolvency proceedings.
So, while choosing debt financing, it is important to understand our monetary capacity to service the debt periodically, without fail.
What Is the Debt Service Coverage Ratio?
Debt Service Coverage Ratio or DSCR is an indicator of a borrower’s monetary capability or liquidity to service a loan. Both business and personal loan-approving officers often check DSCR while assessing loan applications. Corporate loan agreements also include payment terms conditional to the DSCR of a company, especially real estate businesses.
The standard formula for calculating DSCR:
Debt Service Coverage Ratio = (Company’s Annual Net Operating Income / Company’s Annual Debt Payments)
For example:
- A company’s annual income is ₹100, and it needs to pay ₹100 on interest and other loan-related payments. The DSCR will be (₹100/₹100) or 1.
- The same company earns an annual income of ₹150, and it needs to pay the same ₹100 on interest and other loan-related payments. The new DSCR will be (₹150/₹100) or 1.5.
- Now, if, for any reason, earnings decrease to ₹80, debt servicing remains at ₹100. DSCR in this new situation will be (₹80/₹100) or 0.8.
There are other practical ways to calculate DSCR for companies. Some of the standard DSCR calculator formula are:
- DSCR = Earning before interest and tax / (annual interest payment + principal payment)
- DSCR = Earning before interest, tax, depreciation, and amortisation / (annual interest payment + principal payment)
- DSCR = (Earning before interest, tax, depreciation, and amortisation – Capex) / (annual interest payment + principal payment)
Equivalence of DSCR in personal finance:
If we apply the concept of DSCR to individuals making loan applications, the representative formula will be = (total annual income + income from other sources) / total EMI to be payable annually.
Implication: DSCR Loan or Debt Servicing
The implication varies based on the value of DSCR for a borrowing company,
- For DSCR > 1, it signifies that the company has more than the necessary income flow to service debts.
- For DSCR <1. The income is less than the monetary liability necessary to service the company’s debts.
So, from the perspective of corporate finance, A DSCR over 1 is the most secure condition for lenders.
However, actual lending decisions may also depend on:
- Rate of interest
- Market conditions
- Credit history of the company
- Revenue projection of the company
A company with a DSCR less than 1 may be required to bear higher interests and other stringent repayment terms.
Advantages and Disadvantages of DSCR
| Pros | Cons |
| DSCR of a company over multiple years can help understand the financial health of the business. | DSCR can be overstated based on which formula a lender is using to calculate the ratio. The use of EBITDA may not always give a correct understanding of liquidity to service debts, as interest on existing loans and debts is obligatory. |
| It can also indicate the efficiency of business operations to generate revenue when comparing a company against its competitors. | Lenders may approve debt service coverage ratio loans based on their business interests. For example, high DSCR may not be lucrative for lenders looking for high-risk, high-return debt assets. |
| The DSCR ratio is comparable across industries. So, banks and financial institutions can use it irrespective of the sector they are lending to. | The calculation of DSCR depends on guidance based on different accounting principles. So, unlike other financial ratios, it can be complex to interpret. |
Also Read More About What is EBITDA?
Conclusion
Debt Service Coverage Ratio can provide key guidance to borrowers on how to maintain a healthy debt financing habit. Use a DSCR calculator to find out your current loan servicing capacity. A company with DSCR bordering 1 should be more careful about increasing its income from operations instead of burning cash through debt financing. Excessive debt burden can compromise business sustainability. Learn about other financial ratios to diagnose the financial well-being of your business and use debts judiciously for better ROI and growth.
FAQs
What does a DSCR of 1.25 mean?
A DSCR of 1.25 means the company earns 25% more cash as income from operations than the basic minimum earning necessary to service its debt.
What is the ideal DSCR?
From a lender’s perspective, any DSCR higher than 1 can be an acceptable situation to approve a loan, depending on the lender’s business interests. However, a DSCR of 2 or more can be considered ideal for both lenders and borrowers. It secures the interests of both parties.
What is the interest coverage ratio?
The interest coverage ratio is a financial ratio that links profitability with expenses on interest payments. The formula is:
Interest coverage ratio (ICR) = EBIT/ Interest expenses
EBIT = Earning before interest and tax
What is the difference between the interest coverage ratio and DSCR?
The debt service coverage ratio considers all the payment obligations related to servicing existing debts in a company’s book and its ability to pay these obligations. ICR considers only the interest expense related to the debts. This is the major difference.