Understanding Debt Service Coverage Ratio

Posted in Lending Articles By Sajhyadri Chattopadhyay-
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The Debt Service Coverage Ratio (DSCR) is like a financial health check for companies in India. It measures if a company earns enough revenue to handle its debts efficiently. In simple terms, DSCR is to businesses what Debt-to-Income Ratio (DTI) is for individual borrowers. It's a crucial number for businesses to ensure that they stay financially fit and can handle sudden monetary challenges. Hence, knowing the ins and outs of DSCR is critical for long-term success. 

What does Debt Service Coverage Ratio Mean for Your Business

Congratulations! You’ve found your DSCR, but is it good or bad? Here’s what it means when your... 

  • DSCR is Less Than 1:

If the Debt Service Coverage Ratio is less than 1, it signifies that a company is not generating sufficient income to cover its debt payments. This could lead to financial strain and difficulties in meeting financial obligations. Moreover, it raises concerns for lenders about the company's ability to repay its debts. 

  • DSCR is Equal to 1

A DSCR of 1 indicates that a company's net operating income precisely matches its total debt service. While technically meeting debt obligations, this leaves no room for unforeseen expenses or economic downturns. It suggests a delicate financial balance for the company and may warrant caution. 

Also check out: Challenges Borrowers Face While Taking a Business Loan

  • DSCR is Greater Than 1

When the DSCR is greater than 1, it signals good financial health. The company generates enough income to comfortably cover its debt payments. A DSCR above 1 provides assurance to lenders and investors that the company has a financial buffer and can handle its debt obligations effectively.

Why is Debt Service Coverage Ratio Important

  • Financial Health Indicator: 

DSCR serves as a crucial gauge of financial health for Indian businesses. A ratio above 1 signifies that a company is generating enough income to comfortably meet its debt obligations. This assures lenders of its financial stability. 

  • Credibility with Lenders: 

Maintaining a healthy DSCR enhances a company's credibility with lenders. A ratio above 1 demonstrates to banks and financial institutions that the business can reliably repay all its loans. This opens the doors to lower interest rates and more favourable loan terms for future financing needs. 

You might also like: Tips to Start a Small Business for Young Entrepreneurs

  • Investment Attractiveness: 

Investors often use DSCR as a key metric when evaluating the attractiveness of an investment in an Indian enterprise. A DSCR above 1 indicates a company's ability to generate sufficient cash flow, making it more appealing to potential investors seeking reliable returns on their investments. 

  • Operational Resilience: 

A DSCR provides insight into a company's operational resilience. A ratio less than or equal to 1 may hint at its vulnerability to economic downturns or unexpected expenses. On the flipside, a ratio above 1 suggests that the business has a financial cushion to weather challenges and uncertainties. 

  • Strategic Decision-Making: 

Indian businesses can use DSCR as a tool for strategic decision-making. Monitoring changes in the ratio over time helps management assess the impact of financial decisions. The company's ability to tackle its debt paves the way for effective financial planning and risk management in future deals.

How to Calculate Debt Service Coverage Ratio

You can calculate Debt Service Coverage Ratio (DSCR) using a simple formula –  

DSCR = Net Operating Income / Total Debt Service

So, how can you find out these two numbers for your business? 

1. Calculate Net Operating Income (NOI): Add up all the revenue (money coming in) and subtract the operating expenses (money going out, excluding interest and taxes). 

2. Determine Total Debt Service: Add up the principal and interest payments on loans. This includes both short-term and long-term debts. 

Let’s look at an example to understand how to find out these numbers and calculate DSCR for your business – 

Suppose a company's annual revenue is ₹15,00,000, and its operating expenses, excluding taxes and interest, amount to ₹5,00,000. Then the NOI would be ₹10,00,000 (₹15,00,000 - ₹5,00,000). 

Similarly, assume the company has a term loan with an annual payment of ₹6,00,000 and an interest payment of ₹2,00,000. Then the Total Debt Service will equal ₹8,00,000 (₹6,00,000 + ₹2,00,000). 

Now, plug these values into the DSCR formula:  

    DSCR = Net Operating Income / Total Debt Service 

= 10,00,000 / 8,00,000 

= 1.25 

How to Improve Debt Service Coverage Ratio

  • Increase Operating Income: 

Boost revenue streams and operational efficiency to enhance net operating income (NOI). This, in turn, improves your DSCR, as you have more income available to cover debt payments. 

  • Debt Restructuring: 

Negotiate with lenders to restructure existing debt terms, potentially lowering interest rates or extending repayment periods. This can reduce the total debt service, positively impacting your DSCR. 

  • Cost Management: 

Identify and cut unnecessary costs without compromising operational efficiency. Efficient cost management increases net operating income, positively impacting your DSCR. 

You may also like: How Can Small Businesses Deal With Emergencies

  • Diversify Revenue Streams: 

Explore new markets or services to diversify income sources. A diversified revenue stream provides a buffer, reducing the impact of fluctuations from a particular line of business. 

  • Monitor and Manage Working Capital: 

Efficiently manage working capital by optimising inventory, receivables, and payables. This ensures a healthy cash flow, boosts revenue, and thereby contributes positively to your DSCR.  

 

Maintaining a healthy Debt Service Coverage Ratio is crucial for securing a business loan in India. Lenders use DSCR as a key metric to assess a company's ability to repay its dues comfortably. With a high DSCR, you can be eligible to negotiate better repayment terms for the funds you want. Check out business loans of amounts up to ₹50 Lakhs at flexible interest rates and long repayment tenures, only on Bajaj Markets. Your road to easy business financing starts here! 

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