Why Is Debt Service Coverage Ratio Important For Banks?

Why Is Debt Service Coverage Ratio Important For Banks?

Why Is Debt Service Coverage Ratio Important For Banks?

While a careful analysis of its financial condition can improve a company's overall performance, it is especially crucial for financial institutions. One of the most significant ratios that they focus on and study to estimate an enterprise's real worth is the debt service coverage ratio (DSCR), which helps banks calculate the company's repayment capacity.

MakaaniQ takes a look at why DSCR is so important for banks:

Who uses it?

DSCR is important for both creditors and investors, but creditors analyse it most often. Bankers are interested in this ratio because it measures a company's ability to repay its current debt obligations.

Why is it used?

DSCR is used as a benchmark to measure the cash-producing ability of a business entity to cover its debt payments. Lenders not only wish to know the cash position and cash flow of a company but also how much debt it currently has and its available cash to pay the current and future debt.

What does the ratio consider?

DSCR takes into consideration all expenses related to debt, including interest expense and other obligations like pension and sinking fund obligation. (a sinking fund is made up of sums of money set aside at intervals, usually invested at interest, to meet a certain future obligation.) In this way, the DSCR is more indicative of a company's ability to pay its debt than just the debt ratio.

How is it calculated?

DSCR is calculated by dividing a company's net operating income by its total debt service costs. Net operating income is the income or cash flows left after all operating expenses have been paid. This is called earnings before interest and taxes (Ebit). On the other hand, total debt service cost refers to all costs involved in servicing the company's debt. This includes interest payments, principal payments, and other obligations.

For instance, suppose Nishant Shah, a local bicycle dealer, is looking to remodel his showroom and has been negotiating with several banks for a loan. Shah is apprehensive about getting the loan, as he has several running loans under his name. His books show that his dealership's net operating profit is Rs 150,000. While his interest expense is Rs 55,000, his principal payment amounts to Rs 35,000. And his sinking fund obligation is Rs 25,000.

Now, the bank will calculate Shah's DSCR by dividing Rs 1,50,000 by Rs 1,15,000 (that is, 55,000 + 35,000 + 25,000), and arrive at a DSCR of 1.3. This means that Nishant makes enough in operating profits to pay his current debt service costs and still be left with 30 per cent of his profits.

What is a bad DSCR?

A DSCR below one indicates a negative cash flow. In such a case, lenders refrain from offering a loan, unless the borrower has a sound income. A high DSCR, on the other hand, makes it easy for one to avail of a loan.

Last Updated: Thu Aug 04 2022

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