Understanding and Calculating the Debt Service Coverage Ratio (DSCR)

The Debt Service Coverage Ratio (DSCR) is a crucial financial metric in India that assesses the ability of individuals and businesses to meet their debt obligations. Lenders widely use it, including the Indian Renewable Energy Development Agency (IREDA) and credit rating agencies like CRISIL.

IREDA mandates a minimum DSCR of 1.2x for renewable energy projects to ensure the project can generate sufficient cash flow to cover its debt payments. This requirement helps mitigate the risk of default and safeguards lenders' interests.

In the infrastructure sector, credit rating agencies like CRISIL use DSCR to evaluate the creditworthiness of infrastructure trusts, such as highway projects. A higher DSCR indicates a stronger ability to generate adequate income for debt repayment, a key factor investors and lenders consider.

Most commercial lenders in India follow similar standards, emphasizing the need for borrowers to maintain a healthy DSCR.  Understanding how to calculate the DSCR can help borrowers manage their finances better and prepare for loan applications. This article explains what DSCR is, its significance, and the step-by-step process for calculating it accurately.

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Understanding and Calculating the Debt Service Coverage Ratio (DSCR)

The Debt Service Coverage Ratio (DSCR) is a financial metric that measures a company's ability to pay its debt using its available cash flow. It is a simple way to determine if a company can cover its debt payments, including the principal and interest on loans, bonds, or lines of credit. A higher DSCR indicates that a company is more capable of meeting its debt obligations. Businesses, banks, and investors use the DSCR to evaluate the risk of lending money or investing in a company. A DSCR of 1 or above means the company has enough cash to meet its debt payments, while a DSCR below 1 suggests potential difficulties in fulfilling debt obligations.

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Key Components of DSCR

1. Net Operating Income (NOI): 

Net Operating Income (NOI) is crucial for understanding DSCR. It represents the total revenue generated from a property minus any necessary operating expenses. These expenses include insurance, property maintenance, and management fees, but they do not cover debt-related expenses like loan interest or principal payments. Lenders in India often rely on NOI to evaluate the profitability of real estate investments, ensuring that the property generates sufficient income to cover its debt obligations.

2. Debt Service: Interest and Principal Payments  

Debt service is the total amount required to cover any existing debt's interest and principal payments. When calculating DSCR, the total debt service is a key factor, providing insight into whether the property’s income is sufficient to meet its debt repayment obligations. As of August 2024, lending rates in India for banks like HDFC, SBI, and PNB start from around 8.95% annually, but this rate can vary depending on factors such as loan type, borrower profile, economic conditions, loan amount and tenure, and specific bank policies. For instance, the rates fluctuate based on the Weighted Average Lending Rate (WALR) and the 1-year median Marginal Cost of Funds-based Lending Rate (MCLR). Founders must ensure their property's income can comfortably cover these potential loan payments. 

3. Adjustments: Inclusion of Cash Taxes and Exclusion of Capital Expenditures 

While calculating DSCR, certain adjustments are made to accurately represent a property's financial health. Cash taxes paid by the property owner are included in the calculation, as they represent an actual expense that impacts cash flow. On the other hand, capital expenditures (expenses for long-term investments, such as property improvements) are typically excluded. This is because they do not reflect the day-to-day operating expenses directly affecting the property's ability to cover its debt. By focusing on regular cash flow, lenders get a clearer picture of how well the property can meet its debt obligations.

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The Formula for Calculating DSCR

Standard DSCR Formula

The Debt Service Coverage Ratio (DSCR) measures a company's ability to cover its debt payments using its net operating income. The standard formula is:

Where:

Net Operating Income (NOI): The company’s total revenue minus operating expenses, excluding taxes and interest payments. It's similar to Earnings Before Interest and Taxes (EBIT). ​

Net Operating Income = Revenue−COE

COE = Certain operating expenses 

Debt Service: The total debt obligations due in a year, including principal and interest payments.

Total Debt Service = Current debt obligations

Example of Calculating DSCR

A startup in India has the following financial information:

Net Operating Income (NOI): ₹10,00,000 (after subtracting operating expenses, excluding taxes and interest)

Debt Service (Total annual debt obligations): ₹6,00,000 (includes both interest and principal payments)

Step 1: Using the Standard DSCR Formula

DSCR = Net Operating Income \ Debt Service

DSCR = ₹10,00,000 \ ₹6,00,000 = 1.67

Interpretation:

A DSCR of 1.67 means the startup has 1.67 times the income required to cover its debt payments. This indicates a comfortable financial position, as the company earns significantly more than it needs to pay off its debt.

EBITDA and Its Components

EBITDA stands for Earnings Before Interest, Taxes, Depreciation, and Amortization. It is a financial measure used to assess a company’s operating performance without accounting for non-operating expenses like interest and taxes and non-cash charges like depreciation and amortization. This metric helps understand how well a company generates profit from its core operations.

Here’s a breakdown of each component of EBITDA:

1. Earnings: The company's profit, usually net income, before deductions.
2. Before Interest: Interest expenses are payments made on loans or other forms of debt. EBITDA excludes these to focus on the business's profitability without considering its debt structure.
3. Taxes: Companies pay taxes on their income. EBITDA removes taxes from the equation to provide a clearer view of operational efficiency, regardless of tax policies or rates that may differ by region.
4. Depreciation: This represents the loss in value of tangible assets like machinery, buildings, or vehicles over time. By excluding depreciation, EBITDA shows earnings before accounting for the wear and tear of these assets.
5. Amortization: Similar to depreciation, amortization spreads out the cost of intangible assets like patents or goodwill over time. EBITDA removes this non-cash expense to highlight the company’s current operating performance.

Using EBITDA can give founders a better idea of the company's profitability from its main business activities without the influence of financing, accounting decisions, or tax environments. However, it’s essential to note that EBITDA does not include asset depreciation costs, which might be significant for businesses with many physical assets.

Alternative Calculations for DSCR Using EBITDA

An alternative way to calculate DSCR uses EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization):

DSCR = EBITDA \ Debt Service

This formula uses EBITDA to clarify the company’s operating performance before accounting for financing costs and tax obligations.

Alternative Calculation Using EBITDA

Suppose the startup’s EBITDA is ₹12,00,000. The DSCR using EBITDA would be:

DSCR = EBITDA \ Debt Service = ₹12,00,000 \ ₹6,00,000 = 2.0

When using EBITDA, the DSCR increases to 2.0, showing even stronger coverage of debt obligations before accounting for taxes, depreciation, and amortization.

When to Use EBITDA for DSCR Calculation?

Capital-Intensive Startups: Startups in sectors like manufacturing or technology, where heavy investments in equipment and technology are common, might have high depreciation or amortization costs. EBITDA can provide a more realistic picture of their operational efficiency and debt repayment capacity.

Early-Stage Startups: For early-stage startups with minimal profits but high growth potential, using EBITDA can help showcase their true operational strength without the noise of initial capital costs.

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Interpreting DSCR

1. What Constitutes a Good DSCR?

A good DSCR typically means a company has sufficient cash flow to cover its debt payments. A ratio of 1.0 means the business has enough income to meet its debt obligations. Generally, a DSCR above 1.2 is considered healthy, as it indicates the company has a buffer for any fluctuations in income. 

For example, a DSCR of 1.6 means the company can cover its debt payments 1.6 times with its current cash flow. Lenders often look for a DSCR between 1.2 and 1.4 to be confident that the business is not at immediate risk of defaulting on its payments.

2. Industry Benchmarks and Lender Standards

Different industries and lenders have varying benchmarks for DSCR. In India, most lenders prefer a DSCR of at least 1.25 for small and medium-sized enterprises. Some lenders may accept a slightly lower ratio if the borrower has strong assets or a long-standing relationship with the bank. 

However, high-risk industries might require a higher DSCR, often closer to 1.5 or above. Larger, more established businesses might aim for a DSCR of 2.0 or higher, reflecting strong financial health and the ability to manage debt comfortably.

3. Implications of Various DSCR Levels

DSCR Below 1: 

If the DSCR is less than 1 (e.g., 0.85), the business does not generate enough cash flow to cover its debt payments. This suggests financial strain and the borrower might need personal funds or additional financing to meet their obligations. Lenders see this as high risk and may hesitate to provide loans.

DSCR Equal to 1:  

A DSCR of 1.0 indicates that the company generates just enough income to cover its debt payments. While it shows the business can meet its current obligations, it also means there is little room for error. A slight dip in revenue or unexpected expenses could put the company at risk of default.

DSCR Above 1: 

A DSCR greater than 1, such as 1.6, signals the business has a comfortable cushion to cover its debt payments. It provides reassurance to lenders that the company is financially stable. A DSCR of 2.0 or higher is often seen as ideal, as it shows that the company has a strong cash flow, minimizing the risk of default.

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Improving DSCR

Improving your Debt Service Coverage Ratio (DSCR) can make your business more attractive to lenders. Here are some practical strategies to enhance your DSCR:

1. Strategies to Increase Net Operating Income

• Increase Revenue: Focus on increasing sales or adding new revenue streams. This can include launching new products, expanding your market reach, or implementing targeted marketing strategies to attract more customers.
• Optimize Pricing: Review your pricing strategy. If possible, adjust prices better to reflect market demand and your product's value.
• Improve Customer Retention: Retaining existing customers is often more cost-effective than acquiring new ones. Implement loyalty programs, offer promotions, or improve customer support to increase repeat business.
• Diversify Income Sources: Explore adding complementary services or products to diversify your revenue streams and reduce reliance on a single source of income.

2. Methods to Reduce Debt Service

• Refinance Loans: Consider refinancing your current loans to secure lower interest rates or extend repayment terms. This can reduce your monthly debt payments and improve cash flow.
• Consolidate Debt: Combining multiple debts into a single loan with a lower interest rate can reduce monthly payments.
• Negotiate with Lenders: Discuss possible adjustments to loan terms with your lender. Some lenders might offer options like interest-only periods or payment holidays, especially if you have a history of on-time payments.

3. Specific Actions to Improve DSCR

• Refinancing Loans: Shop around for lenders offering more favorable terms. A lower interest rate or an extended loan term can significantly reduce your monthly debt service, easing the pressure on your DSCR.
• Reducing Operating Expenses: Review your operating costs and identify areas for savings. This might include negotiating with suppliers for better rates, reducing utility costs, or optimizing staffing levels without compromising business quality.
• Increasing Revenue: Develop strategies to boost sales, such as enhancing your marketing efforts, expanding to new markets, or offering promotions. Higher revenue directly increases your net operating income, improving your DSCR.

By implementing these strategies, you can work towards a healthier DSCR, making your business more financially stable and appealing to lenders. Businesses like WeVois have achieved impressive growth, experiencing a 2.7x increase in just two years through smart financial planning and sustained revenue growth. If you're ready to explore how to replicate similar success, Recur Club can provide tailored financial solutions to support your journey. Learn more about how WeVois grew 2.7x in two years.

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Common Mistakes in Calculating DSCR

1. Incorrectly Determining Principal Repayments: 

One common mistake is misunderstanding how to account for principal repayments. While calculating DSCR, interest and principal repayments on debt should be considered. Some might only include interest payments, leading to an inflated DSCR. Always ensure that the total debt service, including interest and principal, is accurately included in the calculation.

2. Confusing EBITDA with Other Measures: 

EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) is commonly used to measure operating income. However, it's easy to mix EBITDA with other financial terms like net income or gross profit. Remember that EBITDA focuses on core operational performance, excluding other expenses. When calculating DSCR, the correct EBITDA figure ensures a clear view of the company’s ability to meet its debt obligations.

3. Excluding Relevant Expenses Like Real Estate Purchases: 

Startups may sometimes exclude significant expenses such as real estate purchases, distorting the DSCR. While these expenses might not be frequent, they substantially impact the company's cash flow. Failing to account for such costs can result in an inaccurate DSCR, misleading stakeholders about the business's financial health. Always include all relevant expenses to get an accurate ratio.

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Conclusion

The Debt Service Coverage Ratio (DSCR) is essential for businesses to assess their financial stability and meet their debt obligations. For founders, keeping an eye on DSCR is key to staying financially strong, securing better financing, and making smart decisions for growth.  By adopting strategies to optimize cash flow and manage debt effectively, companies can strengthen their DSCR, paving the way for sustained business success.

If you're looking to optimize your company’s flexible financing, Recur Club is here to help. You can explore tailored debt capital solutions that match your business needs with a dedicated capital expert. Get started with Recur Club today and let your capital grow with you.