What is Debt Coverage Ratio
Debt coverage ratio is a financial ratio of the comparison between net operating income with total debt service. The debt coverage ratio measures the available cash flow to pay for the liabilities expenses. The higher the debt coverage ratio reflects the higher ability to pay debts.
The debt coverage ratio is computed by dividing net operating income (operating income – operating expense) by the total debt service. Therefore, the DCR value of 1.00 means the operating income is exactly equal to the debt service.
- The value of DCR is more than 1 means the company’s net operating income is more than debt service.
- The value of DCR is less than 1 means the company’s debt service excess operating income
Thus, the higher value of the DCR, the higher the available cash flow pay the debt service. In contrast, the lower DCR the lower number of cash flow available to repay debt. However, a good debt coverage ratio value depends on the industry and the company’s current stage of growth.
The higher the debt coverage ratio, the higher ability to pay debts.
Normally, the debt coverage ratio is used by the lender to determine the individual or the corporate’s debt servicing ability (ability to pay the debt) to make sure they have the ability to generate enough cash flow to cover their debt.
Debt Coverage Ratio Formula & Calculation
The debt coverage ratio (DCR) can be calculated by dividing the company’s net operating income by the company’s total debt service, or the following debt coverage ratio formula:
DCR = Net operating income / Total debt service
or
DCR = EBITDA / Total debt service
Where:
- Net operating income = Operating income – Operating expenses
- EBITDA is earnings before interest, tax, depreciation, and amortization.
- Debt service includes annual interest payments and principal payments on debt.
For example, let’s say the Feriors company has a net operating income of $200,000 and a total debt service of $10,000, the debt coverage ratio will be 200,000 / 10,000 = 20.
The DCR value of 10 means the Feriors company has an operating income 20 times greater than the debt service.
Note: The debt coverage ratio (DCR) is also known as the debt service coverage ratio (DSCR).
FAQs
Debt coverage ratio is a financial ratio of the comparison between net operating income with total debt service. The debt coverage ratio measures the available cash flow to pay for the liabilities expenses.
The debt coverage ratio (DCR) can be calculated by dividing the company’s net operating income by the company’s total debt service, or the following debt coverage ratio formula: DCR = Net operating income / Total debt service
The higher number with more than 1.00 is a good debt coverage ratio value. The higher the debt coverage ratio reflects the higher ability to pay debts.
