Debt Service Coverage Ratio (DSCR) is a financial metric used to assess the ability of a borrower to repay its debt obligations from its cash flows. It is commonly used in real estate finance, project finance and other lending activities to evaluate the creditworthiness of the borrower.
The DSCR calculation is expressed as a ratio, where the numerator represents the borrower’s cash flows and the denominator represents its debt obligations. The formula to calculate DSCR is as follows:
DSCR = Net Operating Income (NOI) / Total Debt Service
Where:
Net Operating Income (NOI) is the property’s or project’s cash flow after deducting operating expenses, but before paying taxes and interest.
Total Debt Service is the total amount of debt payments (principal and interest) that are due in a given period.
A DSCR of 1.0 or greater indicates that the borrower’s cash flows are sufficient to cover its debt obligations. A DSCR less than 1.0 indicates that the borrower does not have enough cash flows to cover its debt obligations and may default on its loans.
Lenders use DSCR to determine the riskiness of lending to a borrower. Generally, lenders prefer borrowers with a higher DSCR, as it indicates a lower risk of default. Lenders may also use DSCR to set loan covenants, which are conditions that must be met in order for the loan to remain in good standing. For example, a lender may require a minimum DSCR of 1.25 as a condition of the loan, to ensure that the borrower has enough cash flows to repay its debt obligations.
In conclusion, DSCR is an important financial metric used by lenders to assess the creditworthiness of borrowers and evaluate the riskiness of lending. It is calculated by dividing the borrower’s cash flows by its debt obligations, and a DSCR of 1.0 or greater indicates a lower risk of default. Understanding DSCR and its calculation is important for borrowers and lenders alike, as it helps to ensure that loans are structured in a way that is sustainable and manageable for the borrower.
