This finance calculation is important for ALL businesses that have any kind of traditional bank loan and regular repayments. The bank wants to know your ability to meet debt obligations and this ratio is a pretty clear indicator of that.
Example Sheet with DSCR: https://docs.google.com/spreadsheets/d/1cJLlHVKbbqhkdFNqzwTGO0C08Z71Fdvs/edit#gid=213728444
Check out real estate underwriting spreadsheets here.
The calculation is pretty simple:
- Calculate total revenue in a period (don't count extraordinary items)
- Calculate total operating expense in a period (don't count depreciation / interest / extraordinary items)
- Calculate total principal and interest payments in the same period (debt service)
- Subtract Expenses from Revenue in order to get Net Operating Income or EBITDA
- Divide EBITDA or NOI by Debt Service and that is the Debt Service Coverage ratio (DSCR)
- You can also divide Debt Service by EBITDA / NOI to get Debt to Income Ratio
The DSCR of greater than 1 means you have enough operating cash flow to cover your debt obligations. Less than 1 means you can't cover your debt obligations.
A bank will review these figures with your business every so often depending on what kind of risk and exposure they feel they are in with the loans you have for the business. You don't want to be below 1.
This calculation is often focused on in real estate, but it is used in all industries for all kinds of small businesses or any size for that matter.
Remember, you are looking at cash flow from operating activities, so that means you don't take into account depreciation (non-cash item) as that has no impact on your ability to make a payment.
The calculation can get fancy since interest is tax deductible, but we are not covering that here. The most common calculation is looking at available cash in regular operating environments relative to debt obligations.
Another metric you see quite often in real estate that has to do with NOI is the cap rate.
You may also be interested in this real estate model that has three IRR sensitivity tables isolating occupancy, exit cap rate, and hold period.
