Banks and lenders often use a minimum DSCR ratio as a condition in covenants, and a breach can sometimes be considered an act of default.
[1] In personal finance, DSCR refers to a ratio used by bank loan officers in determining debt servicing ability.
In commercial real estate finance, DSCR is the primary measure to determine if a property will be able to sustain its debt based on cash flow.
A DSCR over 1 means that (in theory, as calculated to bank standards and assumptions) the entity generates sufficient cash flow to pay its debt obligations.
In certain industries where non-recourse project finance is used, a Debt Service Reserve Account (DSRA) is commonly used to ensure that loan repayment can be met even in periods with DSCR<1.0 [2] In general, it is calculated by: where: To calculate an entity's debt coverage ratio, you first need to determine the entity's net operating income (NOI).
Thus, financing costs (e.g., interests from loans), personal income tax of owners/investors, capital expenditure, and depreciation are not included in operating expenses.
In the commercial real estate industry, the minimum DSCR set by lenders is 1.25, meaning that the property's net operating income (NOI) is 25% greater than the annual debt service.
[1][5] Typically, most commercial banks require the ratio of 1.15–1.35 × (NOI/ annual debt service) to ensure cash flow sufficient to cover loan payments is available on an ongoing basis.
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.
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.
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.