Debt Ratio – Debt service coverage Ratio: Meaning, Formula

Debt Ratio is one of the financial ratios which compares an entity’s total amount of debt to its total amount of assets, which is used to gain a general idea as to the amount of leverage being used by a entity. Know more about Debt service coverage Ratio from below.

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Debt Ratio Formula

Debt Ratio = Total amount of Debt / Total amount of assets.

Or

Debt Ratio = Total outside liabilities / Total Debt+ Net worth

Total debt or total outside liabilities includes short and long term borrowings from financial institutions, debentures/bonds, deferred payment arrangements for buying capital equipment, bank borrowings, public deposits and any other interest bearing loan.

Importance

If the Debt Ratio of a company is low when compared to the industry average , it means that the company is less dependent on leverage, which indicates that the money borrowed from and owed to others. The lower the percentage, the less leverage a company is using and the stronger its equity position. When a company has a higher Debt Ratio then it means the company is on high risk position to manage on. However, a low debt ratio may also indicates that the company has an opportunity to use leverage to gain the advantage associated with it.

Limitation

Debt Ratio is not a pure measure of an entity’s indebtedness. Because it also considers operational liabilities, such as accounts payable and taxes payable while arriving at Debt Ratio.

Debt Service Coverage Ratio

Meaning

Debt service coverage ratio is a financial ratio which indicates a company’s ability to generate the cash flow through its operations to meet the annual interest and principal payments on debt, including sinking fund payments ,with respect to its net operating revenue.

Formula

Debt service coverage ratio is calculated by dividing a company’s total net operating revenue during the respective financial year by its total required payments on outstanding debts in the same period.

Debt service coverage ratio = Net operating income / Total Debt service costs.

Debt service costs include interest payments, principle payments, and other obligations

Must Read – Debt Equity Ratio

Importance

•  When the Debt service coverage ratio is higher then it’s a sign of good financial health of the company. In other words, the company is able to produce enough amount revenues from its operations to meet its debt servicing costs.
• A ratio of less than one means that the company is unable generate enough operating profits to pay its debt service and must use some of its savings and reserved incomes.
• While deciding whether to lend some amount to any company or individual business entity then a financial institution will generally have various parameters to determine a borrower’s ability to meet the debt.And this debt service coverage ratio is one of such parameters.

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