Businesses often seek out bank financing to secure capital, to help grow the business. This financing often come in the form of a line of credit, revolving demand facilities or term loans with fixed or variable rates. Most agreements with lenders will include financial covenants that the borrower must adhere to as a condition of borrowing. A common financial covenant is the Debt Service Coverage Ratio, which is usually required to be above one, commonly 1.2:1 or 1.25:1.
This ratio represents a business’ net operating income divided by total debt service and measures a borrowers’ ability to service and make payments on their debt. Common interpretations of this formula is Earnings before Interest and Taxes (EBIT) divided by total interest and principal due in the current year. Depending on specific agreements, three common variations are as follows:
- Principal and interest calculated could be based on the principal and interest paid in the current year-end or it could be the expected principal and interest that would be incurred in the following year. For principal plus interest loans, the above distinction could impact the calculations
- Net operating income is commonly considered EBIT however, it may also allow for addback for other non-cash expenses like amortization and depreciation. For capital intensive business this could significantly impact the calculations
- Lastly, because principal repayments are not tax deductible and interest is usually tax deductible, the debt service costs should be gross up by the effective income tax rates.
A company’s ability to obtain new financing or maintain existing financing relies significantly on the ratio calculated above. In addition, improved ratios may provide a basis to apply to reduce the cost of borrowing. Understanding the lender’s specific method of calculation ensures compliance with existing bank agreements.