Debt service coverage ratio is calculated by dividing a company's net operating income by its total debt service costs. Also known as earnings before interest and taxes, net operating income is the cash flow left over after all operating expenses are paid, while total debt service refers to all expenses related to satisfying debt, including interest expenses, principal payments and sinking fund obligations.
The debt service coverage ratio is used to determine a company's ability to make good on debt owed. While important to investors, it is analyzed most often by both current and future creditors, as it measures a company's ability to meet current debt obligations in a timely manner.
Successful companies ideally have a DSCR of greater than one; a ratio of exactly one would mean that net operating income is just enough to cover debt expenses. A ratio of 0.9 indicates a business only generates enough revenue annually to meet 90 percent of its outstanding debts, meaning it must tap into savings to pay debt obligations, making it difficult to get a loan.
If a shop has a net operating profit of $145,000 and interest expenses, principal payments and sinking fund obligations of $25,000, $35,000 and $40,000, respectively, the store has a debt service coverage ratio of 1.4 (145,000/100,000), meaning the business is left with 30 percent of its profits after dues are paid; the business is therefore deemed creditworthy by lenders.