Meaning
Financial metrics used by lenders determine the ability of a borrower to pay current debt obligations from available cash flow. The debt service coverage ratio measures the net operating income against the total principal and interest payments due within a year. A result higher than one indicates that the entity generates enough revenue to cover its liabilities.
Lenders often require a minimum level to be maintained throughout the life of a loan.
Calculation Method
Mathematical formulas for this assessment divide net operating income by the total debt service requirements. Analysts use historical data to verify the debt service coverage ratio during the due diligence phase of a transaction. They exclude non cash expenses like depreciation to arrive at a realistic view of liquidity.
Lender Requirement
Contractual covenants in loan agreements specify the minimum threshold the borrower must meet at all times. Maintaining a debt service coverage ratio above the agreed level prevents a technical default. If the number drops, the bank might demand immediate repayment or take control of project accounts.
Default Trigger
Breach of the financial covenant leads to restricted distributions to shareholders. The debt service coverage ratio indicates potential insolvency before it occurs. It forces the management to prioritize debt repayment over other capital expenditures when cash flow tightens.
