Debt service coverage ratio

Let's say Mr. Jones is looking at an investment property with a net operating income of $36,000 and an annual debt service of $30,000. The debt coverage ratio for this property would be 1.2 and Mr. Jones would know the property generates 20 percent more than is required to pay the annual mortgage payment.

The Debt Service Ratio is also typically used to evaluate the quality of a portfolio of mortgages. For example, on June 19, 2008, a popular US rating agency, Standard & Poors, reported that it lowered its credit rating on several classes of pooled commercial mortgage pass-through certificates originally issued by Bank of America. The rating agency stated in a press release that it had lowered the credit ratings of four certificates in the Bank of America Commercial Mortgage Inc. 2005–1 series, stating that the downgrades "reflect the credit deterioration of the pool". They further go on to state that this downgrade resulted from the fact that eight specific loans in the pool have a debt service coverage (DSC) below 1.0x, or below one times.

The Debt Service Ratio, or debt service coverage, provides a useful indicator of financial strength. Standard & Poors reported that the total pool consisted, as of June 10, 2008, of 135 loans, with an aggregate trust balance of $2.052 billion. They indicate that there were, as of that date, eight loans with a DSC of lower than 1.0x. This means that the net funds coming in from rental of the commercial properties are not covering the mortgage costs. Now, since no one would make a loan like this initially, a financial analyst or informed investor will seek information on what the rate of deterioration of the DSC has been. You want to know not just what the DSC is at a particular point in time, but also how much it has changed from when the loan was last evaluated. The S&P press release tells us this. It indicates that of the eight loans which are "underwater", they have an average balance of $10.1 million, and an average decline in DSC of 38% since the loans were issued.

And there is still more. Since there are a total of 135 loans in the pool, and only eight of them are underwater, with a DSC of less than 1, the obvious question is: what is the total DSC of the entire pool of 135 loans? The Standard and Poors press release provides this number, indicating that the weighted average DSC for the entire pool is 1.76 ×. Again, this is just a snapshot now. The key question that DSC can help you answer, is this better or worse, from when all the loans in the pool were first made? The S&P press release provides this also, explaining that the original weighted average DSC for the entire pool of 135 loans was 1.66 ×.

In this way, the DSC (debt service coverage) ratio provides a way to assess the financial quality, and the associated risk level, of this pool of loans, and shows the surprising result that despite some loans experiencing DSC below 1, the overall DSC of the entire pool has improved, from 1.66 × to 1.76 ×. This is pretty much what a good loan portfolio should look like, with DSC improving over time, as the loans are paid down, and a small percentage, in this case 6%, experiencing DSC ratios below one times, suggesting that for these loans, there may be trouble ahead.

And of course, just because the DSCR is less than 1 for some loans, this does not necessarily mean they will default.

Income taxes present a special problem to DSCR calculation and interpretation. While, in concept, DSCR is the ratio of cash flow available for debt service to required debt service, in practice – because interest is a tax-deductible expense and principal is not – there is no one figure that represents an amount of cash generated from operations that is both fully available for debt service and the only cash available for debt service.

While Earnings Before Interest, Taxes, Depreciation and Amortization (EBITDA) is an appropriate measure of a company's ability to make interest-only payments (assuming that expected change in working capital is zero), EBIDA (without the "T") is a more appropriate indicator of a company's ability to make required principal payments. Ignoring these distinctions can lead to DSCR values that overstate or understate a company's debt service capacity. The Pre-Tax Provision Method provides a single ratio that expresses overall debt service capacity reliably given these challenges.

Debt Service Coverage Ratio as calculated using the Pre-Tax Provision Method answers the following question: How many times greater was the company's EBITDA than its critical EBITDA value, where critical EBITDA is that which just covers its

Interest obligations + Principal obligations + Tax Expense assuming minimum sufficient income + Other necessary expenditures not treated as accounting expenses, like dividends and CAPEX.

The DSCR calculation under the Pre-Tax Provision Method is

EBITDA/(Interest) + (Pre-tax Provision for Post-Tax Outlays),

where Pre-tax Provision for Post-tax Outlays is the amount of pretax cash that must be set aside to meet required post-tax outlays, i.e.,

CPLTD + (Unfinanced CAPEX) + Dividends.

The provision can be calculated as follows:

If (noncash expenses depreciation) + (depletion) + (amortization) > (post-tax outlays), then

(Pretax provision for post-tax outlays) = (Post-tax outlays)

For example, if a company's post-tax outlays consist of CPLTD of $90M and $10M in unfinanced CAPEX, and its noncash expenses are $100M, then the company can apply $100M of cash inflow from operations to post-tax outlays without paying taxes on that $100M cash inflow. In this case, the pretax cash that the borrower must set aside for post-tax outlays would simply be $100M.

If (post-tax outlays) > (noncash expenses), then

(Pretax provision for post-tax outlays) = (Noncash expenses) + (post-tax outlays) − (noncash expenses)/ 1 − (income tax rate)

For example, if post-tax outlays consist of CPLTD of $100M and noncash expenses are $50M, then the borrower can apply $50M of cash inflow from operations directly against $50M of post-tax outlays without paying taxes on that $50M inflow, but the company must set aside $77M (assuming a 35% income tax rate) to meet the remaining $50M of post-tax outlays. This company's pretax provision for post-tax outlays = $50M + $77M = $127M.[5]