Traditional Debt Service Coverage used by Banks
Total Principal & Interest Payments Required in Upcoming Year
This debt service coverage ratio is the most basic and commonly used measure by banks when analyzing whether borrowers will be able to repay commercial loans. It presents accrual-based cash available to service debt against the actual debt payments that will be required over the next year. Note that these debt payments cannot be found on the financial statements. They must be calculated using the payment requirements of lenders.
According to this calculation, Smith Heating and Cooling, Inc. has $62,000 available to service debt. When you add up the monthly debt payments, including interest-only payments on the line of credit and the loan from the owner, the total requirement is around $57,000. This means that the debt service coverage is about 1.09 times.
Banks prefer debt service coverage of at least 120 to 125 percent to be comfortable; this company falls a bit short of that. It is also important to note that, despite the seemingly adequate coverage measured by the other ratios, when all of the debt service requirements are added up, this one shows only marginal coverage.
The most significant flaw with this ratio involves the fact that it is based upon accrual accounting, which does not necessarily measure true cash flow. We’ll present more about cash flow as our studies progress.
Is it true that DSC should be used only for holding companies and companies that utilize only long term debt? DSC does not account for short term debt such as revolving lines of credit. My former boss encouraged me to use DSC on analysis for all businesses but my current boss claims it is not appropriate to use DSC on most operating companies due to the short term debt inaccuracy. It is also very difficult to determine CPLTD from tax returns and some company prepared statements. What is the typical underwriting practice?
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The denominator of this ratio (representing debt service) can and should include payments on short-term debt such as revolving lines of credit. The problem is that payment requirements on short-term debt are, indeed, arbitrary. One way banks handle this situation is to include interest-only payments in the debt service as if the line were fully drawn. A more conservative method might include some principal payments as well, and a very conservative measure would include full principal repayment plus interest. Ultimately, how you include payments on short-term debt is a judgment call.
Sometimes it takes some research to find accurate figures for the current portion of long-term debt and company debt service requirements. You may have to check footnotes or schedules, ask your borrower or potential borrower, or even ask their other lenders and their accountants for information. In any event, to construct a proper balance sheet or to create an accurate debt service coverage ratio, you may have to ask questions, figure it out yourself, or, if all else fails, estimate.
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I train lenders on tax return analysis. DCR comes up and is frequently calculated based on tax returns.
The available amount on an operating line of credit is not something you can find on a tax return so you'll need additional information from your borrower.
Most lenders in my experience base the denominator on the current portion of long-term debt and interest-only on available lines of credit, as if they were fully advance all year.
Another option, especially if the line of credit is not seasoned, is to calculate term debt payments as if the line had to be termed out over 3 or 5 years. That is much more conservative.
I agree, Ken, that the choice of cash or accrual basis will make a difference. Not only in this calculation, but often in trying to compare the financial statements to the tax returns for the same period.
Here is the link to a blog post on the comparison:
http://www.lindakeithcpa.com/ask-linda/ask-linda-2.htm
Linda Keith CPA
www.LindaKeithCPA.com
www.LendersOnlineLibrary.com
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You'll also find more information about debt service coverage on my other website, commercialloananalysis.com.
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