What is the debt service coverage ratio?

Definition

The debt service coverage ratio is cash available to cover the scheduled loan payment, principal and interest together. On the books, this is a cash coverage reading, not a ledger account and not leftover profit on the Income Statement.

A bakery uses it when a $3,000 monthly loan payment is on the calendar. The question is whether operating cash can cover that whole payment, not whether the ovens were busy.

People often shorten the name to DSCR after the full name. A result of 2.0 means two dollars of cash sit next to every dollar of scheduled debt service.

Stay with cash against the full payment when you read it. Operating earnings against interest alone is a different page.

Where it shows up

Cash flow: Related to cash available versus scheduled loan payments.

P&L: Related to interest, which is only part of debt service.

Balance Sheet: Related to the loans being paid.

See also: Principal Payment · Covenant · EBITDA

When you look at the Statement of Cash Flows, this reading is not a printed line. You build it from cash flow from operations, or from a close cousin such as EBITDA, then divide by the scheduled payment.

When the reading is above one, operating cash more than covers principal and interest expense for the period. When it is below one, the bakery has to find cash from savings, new borrowing, or slower vendor payments.

The Income Statement does not print this ratio. Interest is only part of debt service; the principal payment never hits leftover profit.

The Balance Sheet holds the notes payable being paid. This page stays on whether cash can cover the schedule, not on how large the remaining balance is.

How it works

Start with cash the shop produced from running. Many small-shop lenders use operating cash; some use EBITDA as a stand-in.

Then add up debt service for the same window. That is scheduled principal plus scheduled interest, not whichever piece happens to post this week.

Divide cash by that payment total. $6,000 of operating cash against $3,000 of debt service is 2.0.

A result of 1.0 means cash just covers the schedule. A result below 1.0 means the payment has to come from somewhere else.

Stay with the full payment in the denominator. Leaving principal out turns this into a different coverage test.

Some lenders write a floor into a covenant, often 1.2 or 1.25. Missing that floor can put the loan in default even if leftover profit looks fine.

A debt schedule is the supporting list of each loan's balance, payment, rate, and maturity. Use that list so the denominator matches what is actually due.

Free cash flow is a tighter numerator because it already subtracts the capital spending needed to keep running. This page stays on coverage of the scheduled payment, whichever cash figure the lender named.

Example

Crumb & Crust, a neighborhood bakery, produces $6,000 of operating cash this month. Its mixer loan payment is $3,000, of which $2,200 is principal and $800 is interest.

Divide: $6,000 by $3,000. DSCR is 2.0.

The whole $3,000 sits in the denominator. Using only the $800 of interest would overstate coverage and is not this test.

If a slow week drops operating cash to $2,400, the reading falls to 0.8. The $3,000 payment is still due, so the gap has to come from cash already in checking or from a new draw.

If the bakery refinances to a $2,000 payment, the same $6,000 of operating cash reads 3.0. The ovens did not get busier; the schedule got lighter.

The bakery does not post a line that says this ratio. The books already hold operating cash and the loan payment; you divide.

A covenant that asks for 1.25 would be fine at 2.0 and would fail at 0.8. The floor is a contract test, not a printed account.

Common mix-ups

This ratio is not the same as interest coverage. Interest coverage uses operating earnings against interest only; this page uses cash against principal and interest together.

This ratio is not the same as leftover profit. Net income can look fine while operating cash is short of the payment.

This ratio is not the same as the remaining loan balance. A large note can still be easy to service, and a small note can still miss the schedule if cash is thin.

Related terms

• Principal Payment: The portion of a loan payment that reduces the balance owed.
• Interest Expense: The cost of borrowing recorded for the period.
• Covenant: A condition in a loan agreement the borrower must keep meeting.
• EBITDA: Earnings before interest, taxes, depreciation, and amortization.
• Free Cash Flow: Operating cash flow left after the capital spending needed to keep running.
• Debt Schedule: A supporting schedule tracking each loan's balance, payments, rate, and maturity.
• Notes Payable: Formal loan balances owed to a bank or other lender.
• Cash Flow From Operations: Cash generated or used by the day-to-day running of the business.