Debt Service Coverage Ratio

Posted in Finance, Accounting and Economics Terms, Total Reads: 2986

Definition: Debt Service Coverage Ratio

It accounts for the ability of any firm to repay its debts and the periodic financial charges. There are Broadly 2 ways of measuring it:

  • Times-Interest-Earned
  • EBITDA coverage ratio

Times Interest Earned ratio is EBIT (Earnings before Interest and Taxes) / Interest Charges  

EBITDA coverage ratio: This ratio has been developed to account for the deficiencies of “Times-Interest-Earned” (TIE) ratio. The TIE included only interest charges which is not the only fixed financial charges as there might be other charges such as lease etc. Another shortcoming is that EBIT does not represent all the cash flow which can be used to service debt. Debt-Service coverage ratio takes EBITDA-Earnings before Interest, Taxes, Depreciation and Amortization. That is because depreciation and amortization are non-cash expenditures, and therefore available for debt repayment. 

The formula for EBITDA coverage ratio is:

                                                 (EBITDA+ Lease Payments) / (Interest + Principal Payments + Lease payments)     

This ratio must be more than 1. A ratio of less than 1 would mean that the firm does not have enough cash to service its debt. I.e. negative cash flow.

The EBITDA coverage ratio is very useful for relatively short-term lending agencies such as bank. This is because in a short-term, say 5 years, depreciation-generated funds can be used to service debt whereas over a long term, these funds must be reinvested to maintain the corresponding fixed assets of the company. 

Hence, this concludes the definition of Debt Service Coverage Ratio along with its overview.

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