Debt coverage ratio has different meanings dependent on what entity is using it. In the world of corporate finance, it is the amount of cash flow that a company has to service its current debts. This ratio utilizes the net operating income divided by the debt payments due in a year or less. This includes principal, interest, lease payments, and the sinking fund.
It has a different meaning with governments and individuals. For finances of a national government, debt coverage ratio refers to the export earnings required for the country to make its yearly principal and interest payments with the external debts of the nation. With individual finance, banks and their loan officers utilize this ratio to decide on income property loans.
Debt coverage ratios must be higher than one in order for the government, company, or individual to prove enough income to satisfy its present debt obligations. With a DCR under 1, it lacks the means to do so. This ratio is determined by dividing Net Operating Income by the Total Debt Service.
The net operating income turns out to be the revenue of a company less its operating expenses. This does not cover interest payments or taxes. The NOI can also equate to the EBIT Earnings Before Interest and Tax. Investors and lenders which are evaluating the creditworthiness of corporations and companies should use criteria that is consistent when they figure out the DCR.
Total debt service is the term that concerns the present debt obligations. This will include principal, interest, lease payments, and sinking fund all owed in the next year. Balance sheets also include both the long term debt current portion and the short term debt.
When a debt coverage ratio is lower than one, it says that the entity cash flow is negative. With a DCR of .90, the company would only possess sufficient NOI to handle 90% of their yearly debt payments. With personal finance this would mean that the borrower had to access some outside funds each month in order to cover the payments. Lenders usually discourage loans with negative cash flow. They may permit them when the borrower can show a strong outside income.
Lenders almost always consider the debt coverage ratio of borrowers before they extend loans to them. They do not want to loan money to entities with lower than one. Such groups will have to draw on sources outside of their traditional income or borrow more in order to make their debt payments. When the DCR is dangerously close to one, then the borrower is considered to be vulnerable to a slowdown in income. Only a minor setback to its cash flow would mean it would not be able to service the debts. Some lenders will actually insist that the borrowers keep minimum levels of debt coverage ratios while they have a loan balance. In these cases, borrowers whose ratios decline below this minimum level are in technical default.
Lenders can be more lenient on debt coverage ratios when the economy is booming. An expanding economy means that credit is available more easily. This often causes lenders to work with companies and individuals on their lower ratios. The problem is that borrowers which are under qualified can impact the stability of the economy.
In the 2008 financial crisis, subprime borrowers received credit in the form of mortgages without proper consideration of their finances. As such borrowers defaulted in large numbers, the lenders that had made loans to them failed. The largest savings and loan institution Washington Mutual turned out to be the most egregious example of this scenario.