Debt service coverage ratio:
formula and worked example

What the coverage ratio tells a lender

Before a bank lends against a rental flat, a shop or a small factory, it asks a plain question: once the business has paid its running costs, is there enough cash left to meet every loan instalment? The debt service coverage ratio turns that question into one number. A ratio of 1.5 means the income available for debt is one and a half times the payments falling due in the same period.

Lenders are not the only people who need it. A landlord weighing a second mortgage, or a business owner planning a term loan for new machinery, can run the same test on their own figures. The ratio scales cleanly: 240,000 of income against 160,000 of payments reads exactly like 24 lakh against 16 lakh, which makes it easy to compare a small shop with a large one.

What it really measures is cushion. A ratio of 1.0 means every rupee of operating income is already spoken for; anything above 1.0 is room to absorb a slow month, a vacancy or a cost overrun without missing an instalment.

The formula and what goes into each input

• Income: the net operating income for the period, meaning revenue less operating expenses, before interest, loan principal and income tax are deducted.
• Debt service: everything due on borrowings in that same period, principal plus interest, across every loan the property or business carries.

The period matters more than anything else. If income is taken from twelve months of accounts, debt service must also be twelve months of instalments. Mixing a monthly income figure with an annual repayment total is the quickest way to get a ratio that is off by a factor of twelve.

Worked example: 240,000 of income against 160,000 of repayments

Take a small commercial property that earns 240,000 a year after paying its operating costs and carries loans whose instalments add up to 160,000 a year.

1. 1Confirm the income figure is net operating income for the full year: 240,000.
2. 2Add up every loan payment due in those twelve months, principal and interest together: 160,000 (about 13,333 a month).
3. 3Divide income by debt service: 240,000 ÷ 160,000 = 1.5.
4. 4Read the answer as a surplus: 240,000 − 160,000 leaves 80,000 of income after all debt payments.

So each unit of loan repayment is backed by 1.5 units of operating income, and a third of the income is left over after the lender is paid.

How to read a ratio of 1.5, and why 1.0 is the line that matters

Below 1.0, operating income does not cover the instalments, so the shortfall has to come from savings, other income or new borrowing. At exactly 1.0 there is no margin at all. Many lenders like to see something in the region of 1.2 to 1.5 or more on commercial property, but the figure they ask for differs by lender, country and asset type, so treat any single threshold as a convention rather than a rule.

A useful way to feel the number is to ask how far income can fall before the ratio reaches 1.0. That fall is 1 − 1 ÷ ratio. At 1.5 it is one third: income could drop from 240,000 to 160,000 before the loan stops being covered. At 1.2 the same fall is only about 17%, which is why lenders want a larger buffer for businesses with uneven earnings.

What moves the ratio: income up, income down, instalments up

Because debt service sits in the denominator, the ratio responds in proportion to income and inversely to repayments. The table shows a 10% rise in income.

A 10% income gain adds 0.15 to the ratio. The same size move in the other direction hurts: income down 10% to 216,000 gives 1.35. A 10% increase in repayments, to 176,000, drops the ratio to about 1.36. Loans with floating rates can push the denominator up without any change in the business, so a ratio that looks fine today can erode through the loan alone.

Four ways the ratio gets distorted

• Using gross revenue instead of net operating income. Revenue ignores the maintenance, staff, taxes and utilities that must be paid before any lender is.
• Leaving out loans. Vehicle finance, equipment leases, a second charge on the property or a bullet repayment due this year all belong in debt service.
• Counting one-off income. A property sale, an insurance payout or a single large contract inflates income that will not repeat next year.
• Mixing periods. Monthly income against annual repayments, or a half-year of income against a full year of instalments, produces a ratio that looks healthy or alarming for no real reason.

A quick check before you take on more debt

Suppose you are considering a new loan against a property that already produces 240,000 a year. Work through the following before signing.

1. 1List current annual debt service, then add the instalments of the proposed loan.
2. 2Divide expected net operating income by the combined total.
3. 3Repeat with income cut by 15 to 20% to see whether the ratio stays above 1.0.
4. 4Repeat with the interest rate raised if the loan is floating.
5. 5If the stressed ratio drops below 1.0, shorten the amount, lengthen the term or wait.