If you have dealt with business loans, you have probably heard of the term debt service coverage ratio, or DSCR for short. This is the total cash flow of the borrower divided by their debt service for the same period. If the ratio is equal to 1.00, then cash flow is equal to the debt service. Ideally, the ratio should be larger than 1.00 so the borrower can handle some changes in their business, such as reduced revenue or higher expenses, but still be capable of paying their debt service effectively.
While the DSCR is widely known and used, there is not an agreed upon way on how it should be calculated, nor is there a uniform DSCR calculation for each loan request. For example, cash flow may be calculated to mean earnings before interest, taxes, depreciation and amortization (EBITDA) or earnings before interest, depreciation and amortization after taxes (EBIDA). Sometimes, capital expenditures (CAPEX) are subtracted from cash flow. Cash flow may also have need to subtract out realized and unrealized gains from capital gains sales and add back realized losses or unrealized losses. All of these variations can impact the cash flow numerator.
And then there is debt service in the denominator. Debt service can be the individual loan in question, or all loans of the borrower. The debt service may include interest only payments and balloon payments, or it may only include regular installment payments. Debt service might include capital lease payments. Sometimes the debt service could be a hypothetical obligation, which doesn’t represent the actual terms of any loan the borrower currently has.
How DSCR should be calculated will all depend on the nature of the credit requested. Commercial real estate will typically have the most straightforward calculation. This will simply require you take the net operating income (NOI) as cash flow, which is net income plus interest, depreciation, and amortization. You then divide that by the installment payment due over the same period. This assumes there is no other debt in play. CAPEX should generally be subtracted from cash flow if the property is owner-occupied, so the DSCR can be assessed after the need to make capitalized repairs and improvements.
For commercial and industrial loans, DSCR can be complex, depending on the nature of the operation. Generally speaking, EBIDA subtracting out capital gains and adding back capital losses will be your best measure of recurring cash flow in the numerator. CAPEX should also be researched and subtracted out of cash flow. Debt service should include any and all installment payments, interest only payments, and capital lease payments over the same period.
What your target debt service should be all depends on the risk of the operation. Stable and predictable income, like that from residential rental real estate, may only require a DSCR of 1.15x. Whereas, the DSCR from a casino may be 1.50x or higher.
The important concept to keep in mind is DSCR isn’t uniform. Just like all things in commercial finance, it depends. The type of transaction you are analyzing will drive how you calculate both cash flow and debt service, and what the target DSCR should be.