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Debt Coverage Ratio Definition
Debt coverage ratio or debt service coverage ratio is the ratio of net operating income to annual debt service. The annual debt services include interest, principal, sinking fund and lease payments. It is a widely accepted benchmark for measuring an individual or organization’s ability to cover the debts payments with its operating income.
A Little More on What is Debt Coverage Ratio
The formula for calculating Debt coverage ratio is,
Debt Service Ratio = Net operating income / annual debt service.
In corporate finance, it is the ratio of available cash flow and current debt obligations. In government finance, it is the ratio of export earning and country’s external debts. The Debt service ratio is important in personal finance as well. It is one of the criteria the officers look into before approving income property loans.
The net operating income is calculated by subtracting the operating expenses from the company’s total revenue. The operating expense does not include the taxes and interest payments.
Total debt service is the sum total of interest, principal, sinking fund and lease payments due in the coming year. It may seem complicated to calculate the total debt service as the interest payments are tax deductible, but principal repayments are not.
The most accurate formula for calculating total debt service is,
Interest+ [Principle/ (1-Tax Rate)]
The debt service coverage is important to the lenders and investors to judging a company’s creditworthiness. They may compare the figure of different companies before investing in one. The companies also compare the DSR of different years or quarters to evaluate their own performance and gauge the creditworthiness.
A DSR value less than 1 indicates the cash flow of the company is not enough for covering all the debt services. Like, if the value 0.8 the company would be able to cover only 80% of their debt services with their net operating income, thus they need to draw money from outside sources to cover their debts.
At times the lenders agree to lend money to a borrower with a DSR less than one if they believe the borrower has strong outside resources. The DSR value 1 signifies the company has just enough net operating income to cover its debt services and a minimum decline in net operating income may result in failure of paying the debts. They are considered to be highly vulnerable. There’s no standard minimum limit for getting a loan approved and depends on the lender and macroeconomic condition. In a growing economy, loans are more readily available than in a declining economy.
Some lenders may determine a fixed DSR to be maintained by the borrower during the period when the loan is outstanding. Such agreements consider the borrower a defaulter if the borrower fails to maintain the level.
Reference for Debt Coverage Ratio
Academic Research on Debt Coverage Ratio
Cash flows Another approach to the ratio analysis, Giacomino, D. E., & Mielke, D. E. (1993). Journal of Accountancy, 175(3), 55. According to the research carried out in this paper, a new approach to studying the ratio analysis was developed and also the cash flow analysis was also discussed in this study.
Capital structure and the informational role of debt, Harris, M., & Raviv, A. (1990). The Journal of Finance, 45(2), 321-349. According to this study, a theory which explains the capital structure as a base explanation on the effect of debt on investors’ information as regards the firm and also on their capacity to supervise management. This paper assumes that managers are unwilling to lay-down control and also hesitant to provide adequate information that could give such a robust outcome. Debt according to this paper is defined as a disciplining device that allows creditors the chance to coax firms into bankruptcy and also produce useful information to investors. This paper explains the time path of the level of debt and acquires a comparative static result on the probability of default, debt level, bond yield etc.
The power of cash flow ratios, Mills, J., & Yamamura, J. H. (1998). Journal of Accountancy, 186(4), 53.
The effects of debt covenants and political costs on the choice of accounting methods: The case of accounting for R&D costs, Daley, L. A., & Vigeland, R. L. (1983). Journal of accounting and economics, 5, 195-211. Firms have the ability to capitalize on all or most of their research and development costs (R and D) until 1974. The choice between these two aforementioned alternatives is therefore assumed to be marked by the outstanding debt covenant which allows accounting figure as regards interest coverage, leverage and the ability to pay a dividend. This assumption was explained in this research paper and in addition, the use of public debt as opposed to that of the private is assumed to affect the accounting choice which is due to the difference in the renegotiation costs. The result from the examination carried out in this paper show that firms with capitalized R and D cost were greatly leveraged, closer to dividend restriction and smaller than firms with a robust R and D cost.
How does financing impact investment? The role of debt covenants, Chava, S., & Roberts, M. R. (2008). The Journal of Finance, 63(5), 2085-2121. This paper classified the debt covenant and the transfer of the right to control through which the financing frictions influence the corporate investment. Adopting the knowledge of the regression discontinuity design, this paper shows that capital investment begins to fall sharply as a result of a violation in the financial covenant the moment creditors adopt the use of increasing the loan as a threat to intervene in management. The reduction observed as concentrated in situations in which information and agency are relatively severe.
The declining credit quality of US corporate debt: Myth or reality?, Blume, M. E., Lim, F., & MacKinlay, A. C. (1998). The journal of finance, 53(4), 1389-1413. This paper takes into account the activities of recent years as regards the number of downgrades I corporate bond ratings which was found out to have exceeded the number of upgrades thereby causing some of the analysis carried out by past scholars to conclude that the quality of credit given by the United States corporate bond has decreased. This paper, however, considers an alternative explanation of this notable decrease in quality of credit and the cause of this decrease was found to be the usage of a more stringent standard by the rating agencies. This study also suggests that the rating standards have indeed become more stringent and this shows that a part of the downward trend in ratings is as a result of the changing standards.
Developing ratios for effective cash flow statement analysis, Carslaw, C. A., & Mills, J. R. (1991). Journal of Accountancy, 172(5), 63. This paper studies the developing ratios which studied the effective cash flow statement analysis. This analysis was explained exclusively in this paper.
Industrial bond ratings: A new look, Belkaoui, A. (1980). Financial Management, 44-51. According to this paper, a test was developed to test a number of the discriminant model which was used for guessing the bond rating. This paper used an economic rationale for choice variables. The model effectively and efficiently estimated a 62.8% of the rating I an experimental sample and the result obtained by those in control sample was estimated to be 65.9%.
Financial goals and debt ratio determinants: A survey of practice in five countries, Stonehill, A., Beekhuisen, T., Wright, R., Remmers, L., Toy, N., Pares, A., … & Bates, T. (1975). Financial Management, 27-41. According to this paper, a comparison based on the survey carried out in 1972-1973 on financial executives across 87 firms which was conducted by an international consortium of finance practitioners and professors was taken as a case study in this study. The ranking of the corporate financial goals and the debt ratio determinants by financial officers of several manufacturing corporations in Japan, France, Norway, Netherlands and the United States was also studied in this paper. According to the prescription of the “traditional schools”, a firm is entitled to choosing its debt ratio in other to reduce the cost of capital but the survey carried out by the financial executives arm themselves more with the availability of capital than it cost and with the financial risk.
Corporate international activity and debt financing, Mansi, S. A., & Reeb, D. M. (2002). Corporate international activity and debt financing. Journal of international business studies, 33(1), 129-147. This study gives evidence of the relationships between the cost/level of financing and corporate international activities. Using this evidence as a benchmark, this paper explores the influence of the firm’s international activities on debt financing. Making use of a market-based sample of the United States firms, significant evidence of a non-monotonic relation between the firm’s international activity and that of both the level of debt financing and the cost was studied. In view of this study, the firm’s international activity is associated with a 13% reduction in the cost of debt and a 30% increase in the level of debt financing.
How firm characteristics affect capital structure: an empirical study, Eriotis, N., Vasiliou, D., & Ventoura-Neokosmidi, Z. (2007). Managerial Finance, 33(5), 321-331. According to the investigation carried out in this research paper, a procedure for a sample of 129 Greek companies on the Athens Stock Exchange during 1997-2001 was used as a case study. This firm’s characteristics are analyzed as a major determinant of the capital structure as suggested by the different theories. This paper assumes that the debt ratio at a given time (t) depends on the size of the firm at that same time and the growth of the firm at time (t) as well as its quick ratio at the time (t) and its interest ratio at the time (t).
Firm internationalization and the cost of debt financing: Evidence from non-provisional publicly traded debt, Reeb, D. M., Mansi, S. A., & Allee, J. M. (2001). Journal of Financial and Quantitative Analysis, 36(3), 395-414. This study provides empirical evidence by adopting the use of non-provisional public debt. It should be noted that there is no supporting research result that backs the assumption of the relationship between the cost of debt financing and the level of the firm’s international activity. According to an analysis carried out on a sample of 2,194 United State firm-year observation, it was observed that firms with a larger level of international activity possess better and more efficient credit ratings. It was also discovered that the cost of debt financing is inversely related to the rate of the firm’s internationalization which is more than once incorporated in credit ratings. In total, the result reveals that the inability to incorporate the firm’s international activity in debt pricing to several potential skips variable difficulties.
Risk analysis for revenue dependent infrastructure projects, Songer, A. D., Diekmann, J., & Pecsok, R. S. (1997). Construction Management & Economics, 15(4), 377-382. In this paper, recent activities in most construction companies show the continued use of the alternative procurement process which includes construction management, privatization, design-build and building-operate-transfer. An increase in the use of these methods gives rise to a higher level of uncertainty which is as a result of the profitability and long-term performance. This paper, however, suggests that the enhanced risk analyses tool is a method that can be adopted which helps to improve the information for decision making even before the beginning of the project and also help to increase the performance rate. This study, however, shows a Monte Carlo risk assessment process which can be used to solve problems associated with revenue in the infrastructure (construction) niche.