“Pay off your debt first. Freedom from debt is worth more than any amount you can earn.” – Mark Cuban
What is the debt service coverage ratio?
Measures the ability a business to pay its debt obligations
How is the interest coverage ratio calculated?
Debt service coverage ratio = Operating Income / Total Debt Service. Operating Income is found on your income statement; Total Debt Service includes all debt associated with the business. Principal and interest payments, payables and other liabilities such as lease payments.
What does the debt service coverage ratio mean to my business?
A higher ratio is a positive indicator as the ratio measures the number of times a business’s operating income is available to pay its obligations. The lower ratio is more negative as there is less operating income available to cover interest payments. It can also be considered a measure of risk as the higher the ratio the lower the risk of default and the lower the ratio the higher the risk of default.
Put another way, if a business has a debt service ratio that is less than 1, it would mean that it does not have sufficient operating income to pay is the obligations coming due in the next 12 months. It will likely need and outside source of funding to continue operating, such as an equity contribution or additional borrowings.
As with most financial ratios, trends are more telling than a single period’s ratio. If over time a business’s interest coverage ratio is increasing, it is an indication that its debt is coming less of a burden and risk of default is lower. The opposite is true of the ratio is declining.
Negatives to the interest coverage ratio:
Understanding the specifics of your business is critical. Comparing this ratio to other business, even in the same industry, may not make sense. For example, the steadiness of revenues would be an important factor in determining whether a low ratio is good or bad. If revenues are constant, a low ratio may be acceptable. If revenues are unpredictable, a higher ratio becomes a more important determinant of financial risk.