What is the debt service coverage ratio?
Recent regulatory changes and comments from banking regulators suggest increased oversight for financial institutions and decreased tolerance of credit risks tied to new and existing business relationships.
There are numerous qualitative measures, like past experience with the borrower, which can indicate expected financial performance. However, it’s important to consider and measure over time the key metrics that accompany the 5 Cs of Credit.
One of these key metrics is the debt service coverage ratio.
What is the debt service coverage ratio and what does it mean?
One of the most critical measures in predicting likelihood of default of a business or entity is the debt service coverage ratio. In a 2020 Pepperdine University study, 85% of participating financial institution lenders indicated they saw the debt service coverage ratio as important or very important in developing their lending decisions.
Why is it important in business lending?
The higher a firm’s debt service coverage ratio, the greater its ability to produce enough cash to cover debt payments. This ratio, then, indicates a firm’s capacity to repay its loan obligations. Debt service coverage may be more difficult to calculate for complex borrowers, those with multiple
businesses, owners, or pieces of real estate. In this scenario, the firm has to be analyzed with a robust global cash flow analysis that prevents double-counting of income or debt.
Streamline credit risk decisions on a life-of-loan platform.
How to improve it, if necessary
Since debt service coverage ratios are closely tied with earnings before interest, tax, depreciation and amortization (EBITDA), many of the same methods of improvement will be effective even with little change to debt and interest.
Some of these methods include:
• Focus on increasing EBITDA by lowering operational costs
• Consider refinancing to lower interest rates and therefore interest expense
• Use available cash to pay off more principal, which will in turn make interest payments smaller going forward
To learn more about which metrics mean the most in your credit analysis process, download the whitepaper Quantifying the 5 Cs: Credit Analysis Ratios That Matter.