What is a Debt Service Coverage Ratio – and Why is it Important?

Posted on: December 26th, 2017

Debt Service Coverage Ratio (“DSCR”) measures the ratio of free cash flow to debt service payments. DSCR, not to be confused with the great Prince dance song, “DMSR”, is an important indicator of the financial health of a leveraged company.

This credit statistic is used by your lender to gauge the financial health of your business. The numerator is free cash flow and the denominator is debt service payments.

If you have a debt service coverage ratio of 2.0, you can cover your debt payments which include interest and principal payments on a 2 to 1 basis. This is healthy.

If your DSCR is less than 1.0, then you are underwater and your debt payments exceed your free cash flow. All lenders have slightly different twists on their definition of this ratio, depending on their view of credit risk.

This ratio is important for gauging the level of financial flexibility in your business, particularly in a growth situation. If you have a high ratio, then you have the ability to increase your spending and invest in future growth.

If you have a sub 1.15 ratio, then you are tight and need to consider ways to improve the ratio. The ratio is sensitive to the amount and timing of spending so it is advisable to map out your cash flows on a monthly basis on a historical and projected basis.

Often, a large one time outflow can wreak havoc on the ratio. Such outflow are best handled through custom design of the covenant to exclude one, time project related capex and other extraordinary, non-recurring outlays.

All lenders use a version of the DSCR in their covenants and loan agreements with some lenders emphasizing it more than others. Cash flow lenders such as mezzanine lenders focus on DSCR, as they are highly attuned to the directional growth of free cash relative to debt service.

These lenders have only one way to get repaid, that is through the cash flow, so they require covenant compliance with an escalating ratio to ensure principal repayments are on track. All things being equal, lenders have a high degree of influence over this ratio as they dictate the repayment of principal.

Often companies fall behind budget, yet are still paying interest and not positioned to begin paying back the loan principal on schedule. When this happens, cash flow lenders such as mezzanine lenders will work with the Company and defer payment of principal, as long as they are confident over the overall direction of the company.

In the acquisition financing arena, capital availability is destiny as companies require reliable access to capital to grow over the long term. Unforeseen capital needs usually arise when acquirers least expect it. This can cause some concern for the acquisition financing provider, especially when covenants tighten up and that working capital availability is utilized faster than expected.

Mezzanine debt borrowing is usually a straightforward activity that many companies use for funding of transitional growth. Mezzanine debt lenders are highly transparent about their due diligence approach and their post-closing loan management making it easy for companies to engage with.

Elections have consequences and positive ones at that for the acquisition financing middle market. While much media attention is paid to the direction of the yield curve and the Fed’s likely rate cuts, scant attention is paid to the more important drivers of the acquisition financing market – business psychology and regulatory climate.