What is the Debt Service Ratio?
Debt Service Ratio is a calculation used to help determine the financial health of a company based on the ratio of profits required to repay debts during the coming year.
The Debt Service Ratio is most commonly calculated as: Net operating income divided by total debt obligations due within one year.
Net operating income is the net income + amortization + interest expense + non-cash items. Total debt obligations due within one year include interest and principal repayments as well as lease payments for the coming year.
For example, if a company has $150,000 of net income, $20,000 of amortization, $35,000 of interest expenses for the year and $30,000 of interest payments, $70,000 of principal loan repayments and $12,000 of lease payments in the coming year, then the calculation would be:
$205,000 Net operating income (net income + amortization + interest expense)
$112,000 (interest, principal and lease payments due in the coming year)
= Debt Service Ratio of 1.83. This tells us that the cash flow generated by the company will cover 1.83 times the debt repayments of the coming year.
The higher the Debt Service Ratio, the lower the risk that the company may be unable to repay their debt. The lower the Debt Service Ratio, the higher the risk of investing or lending to the company. The acceptable range of Debt Service Ratio varies based on numerous factors such as the type of debt held, the security for the debt and the stability of the business environment. The bank or potential investors may calculate your company’s Debt Service Ratio and compare it to industry standards to help gauge the risk level of investing in or loaning to your company.
The Debt Service Ratio is a key ratio to monitor as banks often impose restrictions within bank loan covenants on the minimum Debt Service Ratio to help reduce their risk of bad loans.
Dawn Loeffler, BA (Hons), CPA, CA
Manager, Gilmour Group CPA’s
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