Debt Coverage Ratio Formula | Calculation (with Example)

hello everyone hi welcome to the channel
of WallStreetmojo watch the video till the end also if you are new to this
channel then you can subscribe us by clicking the bell ican friends today we
are going to learn a concept which is known as debt coverage ratio Formula one
of the important or or ratio why because of the reason that every bank or the
financial institution or any stakeholder who has landed their money to the
company will make sure that their money is safe their money is in the safe
pocket so they were only way to determine whether their money is safe
whether the money will be in a position to be recovered then for that debt
coverage ratio formula is the most vital ratio that can be used to determine such
level of situation let’s see the formula and let’s understand the whole concept
the debt coverage ratio formula shows something like this the net operating
income divided by the debt service cost I am pretty much sure that you must not
have got a clear idea so will understand this see we use debt coverage ratio
formula to determine how much the net operating income of the firm can
generate in terms of the debt payment it has to make in some period of time now
now let’s look at the debt coverage ratio formula to understand more
properly the debt coverage ratio is equal to your net operating income
divided by the debt service cost so this is going to be the formula for the debt
coverage ratio let’s take an example on this so that you may have some idea
regarding what we are talking about let’s take a practical example to
illustrate how we can calculate the debt coverage ratio formula let’s say there
is a guy called John and he has been looking for his company
name is also John Inc let’s say he has been looking for debt financing they
approach nearby banks and financial institutions so John and John Inc has
found out that the debt service cost would be around let’s say 40,000 debt
service cost let’s say it is around $40,000
everything is in dollars over here for a particular period now do you want to
know whether they’re an operating income is enough to cover the expenses so you
are an accountant of joning and you found out the operating income for the
particular period the operating income for the particular period is 5,00,000 so
what do you think that joning should go for the debt financing
after all see the solution lies in the debt coverage ratio calculation itself
as an accountant you should first see the proportion between the net operating
income and the debt service cost so the formula for the same lies in over here
the debt service coverage ratio will just copy down the formula here and
let’s put down some numbers so our answer should go as is equal to our net
operating income which is 5,00,000 divided by the debt service cost which
is 40,000 so that means over here as per the ratio concern joning has enough
operating income to cover the debt service cost
I mean it’s 12.5 times however the accountant also needs to see whether the
similar companies under the same industry have similar to a closure
results so or the audio countin can also check the norms of the industry to be
certain that 12.5 is a good proportion right so remember one thing basically
what you are trying to do is you are trying to determine whether this 40000 will be will it be able to be covered up in the from the operating
income now instead of this had it been over here 30000 this would
have changed to 0.75 which is actually not good which is less than one so it’s
not in a good condition so you can change the numbers and determine what
exactly is going around now we’ll understand the explanation part this was
the formula this was the example now it’s time to understand the most vital
thing that is your explanation Part see the formula is important to two groups
of an individual the first group of the people are those who would like to
invest in that particular company before they ever loan the amount to the firm so
they want to know whether the firm has enough operating income to cover the
payments right and the second group of individuals are the internal people right the first group of the people are
those would like to invest as just shifting over here would like to invest
and second are the internal people now they can be from the top management you can say the BOD it can be anyone they can be from the top management or they
can report to the top management so can be a VP of Finance or anyone so they use
this formula to see whether the form has internal or whether the format is enough
internal operating income to go for the external sources of finance right and
external sources of finance means I’m talking about the debt finance over here
now by using this formula we get a very clear idea whether the firm with our
form is capable of handling the debt payment regularly this is the vital
thing if they are not irregular that means or there is a default recently the
company called IL & FS had an rating of AAA and within just a week it got
dropped down to D now what is the reason behind this it’s as simple as that
they defaulted in all their loans on the bonds the dimensions everything and from AAA to directly D so remember one thing if the proportion
between the net operating income and the debt payment if it is too low like like
I’m talking about less than one over here it’s better not to go for debt
financed and for the investor it’s better not to take not to loan the
amount to such particular companies which are not in a good State another
example is Jet Airways again a debt stressed company there is no way the
company is able to arrest the stress which has been mounted on the company in spite of the infusion of 26% of the stake of eighty Harlem
which was somewhere close to 8500 crores yet
standing at 14000 crores they couldn’t they couldn’t handle because
they had to they had to work on the operating expenses part so this is how
the condition is then you can imagine how vital this ratio can be in companies
as well as the stakeholders course now let’s understand what exactly is the use
of this particular formula see before the group of the investor decide to loan
the amount of the debt to the company they look at various metrics
one of the metrics are to see whether the company has been has earning enough
operating income to cover the debt payment if not then the investor drop
the idea of investment to the particular company so this ratio debt service may
this ratio may not only be the formula for the investor to to check the
stability of the of the company but they would like to invest into but it
certainly is one of the most important ratio to check whether the firm firm or
the company is worthy or not so you can see over here the comparison that higher
the net income is good and lower the net income or the
net operating income compared to the debt service or the debt cost is bad so
this is the relationship between the earn the net operating income and the
debt service cost now I hope you have got a clear and crystal clear idea
regarding this particular formula the extension of this formula is the DSCR
ratio again one of the vital ratio which the financial institution they consider
before giving a loan to those companies or the firm’s so that’s it for this
particular topic if you have learned and enjoyed watching this video please like
and comment on this video and subscribe to our channel for the latest updates
thank you everyone Cheers

Leave a Reply