The debt service ratio, also known as debt service coverage ratio, is a figure used by investors and lenders to ascertain a company's ability to handle debt. An analyst reviews the company's balance sheet and income statement and uses the information to calculate the ratio. If the ratio is unfavorable, the company is a higher financial risk.
The Formula
Calculate the ratio by dividing income by expenses. The income portion includes the sum of net profit, interest expense, depreciation and amortization. The expenses portion includes the sum of interest expense, prior fiscal year end (FYE) current maturities of long-term debt and new loan obligations. This figure is your debt service ratio.
Income Calculations and Definitions
Net income is the amount of money the company made after it deducts its expenses. Use the figure "net income per the books" located on line one of Schedule M-1 of the balance sheet. Interest expense is located on line 18 of the income statement and represents interest paid to the company's financiers. Depreciation is line 20 of the income statement. It is a deduction for declining value of assets. Amortization is the difference between the cost of acquisition and the current value of assets. If a company claims amortization, it is located on one of the statements attached to the tax returns, usually Statement 1.
Expense Calculations and Definitions
Interest expense is the same figure as mentioned in the income calculations. Add it back on the bottom half of the equation unless you are underwriting a new loan that includes that figure. Current maturities of long-term debt are any loans, notes or other obligations that must be paid within the current fiscal year. This figure is located on the balance sheet. A new loan obligation is only added if you are underwriting a request for new money. If this is the case, calculate the monthly payment, multiply it by 12 and add it to the other figures.
Acceptable Ratios and Testing Frequency
To stay up on the financial health of a company, calculate the debt service ratio at several junctures. Calculate the ratio upon initial investment or loan application and again upon receipt of updated financials. An acceptable debt service ratio is 1.20:1. This means the company's income is enough to pay its debt 1.2 times. The higher the ratio, the better off the company is. If the ratio drops below 1:1, the company represents a riskier venture.
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