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.

As the Fed decides to ease interest rates, middle market acquisition financing structures will benefit in a number of ways. The underlying values of middle market companies will increase leading to a higher enterprise value and lower loan to value ratios for existing portfolio companies of acquisition financing lenders.

The role of acquisition financing is infrequently elevated above a functional transactional one. When a business needs financing to acquire, they go to the market and source acquisition financing to supplement their equity investment to close the deal. Despite existing in many different forms, acquisition financing is rarely explained in terms of the value it brings to the acquirer.

Acquisition financing underwriting usually focuses on business and financial issues that underpin the stability of cash flow. Providers of acquisition financing usually validate the durability of a company’s competitive advantage and the depth of its resource base. Environmental issues are usually not a major part of the analysis in today’s service and technology-based economy.