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Debt-Service Coverage Ratio: A Useful Financial Measurement for Assessing Future Debt Recovery

October 14, 2019 | admin

Debt-service coverage ratio (DSCR) is a vital corporate finance tool. It’s how lenders measure an organization’s available cash flow to pay off debt obligations, essentially a credit score for a business. Even governments use DSCR to determine other countries’ ability to pay for the goods it exports.

For perspective, the U.S. government’s public debt hit a historic high of $22 trillion in Feb 2019, according to the U.S. Treasury Department. This matters because creditors use this information to determine whether to do business with the U.S. By 2029, the Congressional Budget Office estimates the national debt will rise to 93% of the gross domestic product (GDP).

Just because an organization has income and clients doesn’t necessarily mean it’s truly generating revenue. Uber was widely hailed for drawing historic investments, but it spent 2019 losing billions of dollars every quarter. It lost $5.2 billion in the second quarter alone. Theranos is another success story that went from $4.5 billion in 2015 to zero almost overnight.

Failure to calculate an organization’s DSCR, rather than relying on income statements, can lead a creditor holding the bag when a company collapses and defaults on its obligations.

How to Calculate Debt Service Coverage Ratio

DSCR is just one of many metrics lenders use to determine an organization’s ability to pay, however, it’s the most important. It’s the ratio of net operating income as a multiple of debt obligations due within one year. This includes lease payments, sinking-funds, and any other loans, both principal and interest, along with operating expenses.

Like personal credit scores, DSCR ratios are calculated differently by different creditors.

In general, a ratio of one or above indicates that there are enough funds to cover upcoming debt payments, while a ratio of below one warns of the potential inability to fully repay the debt. The higher the DSCR from a borrower, the better for the business collecting the debt. Most importantly, creditors can use the DSCR at the outset when deciding whether and how much to lend.

Net DSCR vs. Gross DSCR: Which One to Use and When?

The biggest differentiating factor between individual creditors is between net DSCR and gross DSCR. Each places importance on different financial factors that impact the debtor’s ability to pay.

When to Use Net DSCR

When using the operating income to cover debt service, a lender or creditor is looking at the borrower’s net DSCR. This ratio is the safest and most conservative measure to ensure debt repayments because net DSCR leaves out non-cash operating expenses such as depreciation that could be potential funding sources for debt service.

However, it may be too rigid to use net DSCR alone when examining an entity’s creditworthiness. By doing so, the business trying to find clients to extend credit to may be missing out on some good opportunities that may not be so obvious. Operating income is an accounting number and often doesn’t agree with actual cash. As a result, operating income could be less than the actual cash on hand, underestimating a client’s ability to service its debt.

An alternative measurement to assess debt service coverage would be the so-called gross DSCR, which compares revenue to debt service.

When to Use Gross DSCR

Sometimes, creditors may also look at the size of a borrower’s revenue, especially the rate at which it can grow over time. A borrower’s revenue-generating ability can mean more to the health of a business than income in the long run, which is better insurance against non-payments of debt.

A larger revenue doesn’t guarantee immediate debt serviceability because of proportionately larger expenses that likely accompany and as a result, little change in operating income if any. But there can be a potential opportunity whereby the borrower is able to grow its business and cut down on costs over time, earning enough operating income to cover its debt after all.

Some borrowers with a poor net DSCR but healthy gross DSCR may worth a deeper look from creditors that are willing to take a calculated and informed risk. By understanding the difference between different versions of DSCR, sophisticated lenders can seize opportunities whose payoffs may not be visible to others.

Practical Issues When Applying DSCR

When using DSCR to assess a borrower’s debt coverage, creditors must consider the uniqueness of individual revenue models. For example, real estate or nonprofit entities are very different from traditional commercial businesses like a manufacturing plant or logistics company. How they earn their operating income to cover the debt will differ too

DSCR for B2C

B2C businesses depend on transactions, and tomorrow’s sales aren’t guaranteed on the back of today’s. B2C companies need a sturdy infrastructure in place that includes marketing, customer retention, and sales to show sporadic or seasonal boosts aren’t the only thing holding the business above water.

DSCR for B2B

In a commercial real estate operation, developers often make a down payment before they can secure a loan, which is not the case for most of the other business operations. In addition, the loan amount a developer needs is based on the sale price of the property being acquired, whereas there isn’t a set reference as to how much a business must borrow without having some flexibility to adjust.

Suppose a real estate developer needs a $500,000 loan for a property, and the down payment is 20%, or $100,000. In this case, the developer must be able to borrow $400,000, or else the deal would fall through. Now, also assume that projected total rental income over the loan period is just a bit above $400,000. With that income level, the developer might think it could get the full $400,000 loan. However, if a creditor requires a DSCR of 1.25 for additional safety, the total loan proceeds available would be only $320,000.

In real estate, there’s no room to adjust for the $80,000 shortfall by scaling down operation, because the property’s sale price is set in stone. Real estate entities must remember that a higher DSCR holds more importance than that for other commercial entities.

DSCR for Non-Profit

Nonprofit organizations present another unique case for using DSCR. By definition, a nonprofit entity is not in it to maximize its operating income, so they don’t typically have surplus profits.

However, nonprofit organizations hold assets just like any other organization. Comparing a nonprofit’s liquid assets to its debt gives a better indication of the entity’s debt coverage ability. Also, keep in mind, a major source of funds for nonprofits is through fundraising. If a non-profit has efficient fundraising activities, taking on some additional debt would be less risky as opposed to an entity with weak fundraising performances.

Why DSCR Matters

Creditors demand a healthy DSCR, and there are certain considerations as they try to gauge their chances to recover their debt. Essentially, they want to leave enough margins for both operating income fluctuation and a borrower’s hidden indebtedness.

When a borrower’s operating income drops, without a healthy margin in DSCR, the ratio can easily fall below one, greatly reducing a creditor’s chance to get paid fully. On the other hand, without a high enough DSCR, a sudden increase in a borrower’s indebtedness such as drawing on a line of credit facility from another lender brings down the borrower’s actual DSCR and weakens its ability to service existing debt.

Commercial debts are often already 90-120 days in arrears before they’re even noticed. It’s not uncommon to see Net 90 payment terms in commercial operations. So, when a business like Theranos went under, there were debtors with potentially three months or more worth of operating revenue on the line. Many of these debtors end up left empty-handed, even after expensive litigation.

With stakes this high, a commercial lender can’t afford to drop the ball on debt collections. Payment of these outstanding debts may be the only thing keeping the doors open and servicing both customers and investors.

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