How do you measure debt service capacity? DSCR and net debt/EBITDA
How much debt a company can carry depends less on the amount on its balance sheet than on how quickly, and how comfortably, the cash its business generates can repay it.
Debt service capacity is a company’s ability to meet principal and interest payments on its financial debt from the cash its operations generate. The size of the debt says little on its own: the same amount can be comfortable for a company with strong cash generation and unsustainable for a weak one.
Two kinds of indicator are commonly used to measure capacity: the debt service coverage ratio and leverage ratios.
Debt service coverage ratio (DSCR)
DSCR is the ratio of cash available for debt service in a period to the principal and interest due in the same period:
DSCR = Cash available for debt service / (Principal + Interest payments)
The numerator can be defined in different ways. A common approach starts from EBITDA and deducts taxes paid, required capital expenditure and the increase in working capital. What matters is that the definition is written down and applied the same way every period.
| DSCR | Reading |
|---|---|
| Below 1 | Operating cash does not cover debt service; the gap is closed with new financing or asset sales. |
| Around 1 | Debt can be serviced, with no margin for error. |
| Clearly above 1 | There is a buffer against an unexpected fall. |
The threshold lenders look for varies by sector and type of facility; there is no single right level.
Net debt / EBITDA
Net debt is financial debt minus cash and cash equivalents. Net debt/EBITDA gives a rough idea of how many years it would theoretically take to repay the debt at current operating performance. The higher the ratio, the higher the leverage.
It is useful for quick comparisons but has two limits: EBITDA is not cash (it ignores tax, capital expenditure and working capital needs), and it does not show the maturity profile of the debt. It should therefore be read together with DSCR.
A hypothetical example
Suppose a company has annual EBITDA of TRY 40 million. With TRY 6 million of taxes paid, TRY 8 million of required capital expenditure and a TRY 4 million increase in working capital, cash available for debt service is TRY 22 million. If principal due that year is TRY 18 million and interest TRY 9 million:
DSCR = 22 / (18 + 9) ≈ 0.81
Although the company is profitable on paper, operating cash covers only about 81 percent of debt service. Where the missing TRY 5 million will come from is the starting point of a debt restructuring discussion. If spreading principal over a longer period cut annual principal to TRY 12 million, the ratio would rise to about 1.05.
Projecting capacity forward
Last year’s ratio does not guarantee future capacity. Capacity analysis should therefore be done on a projection: how much cash will operations generate in the coming years, and how will the debt schedule run? That needs a model in which the income statement, balance sheet and cash flow are linked; I explain why in Why does a business plan need three statements?
Scenarios are part of the analysis too: where does DSCR go if sales fall by 10 percent or interest rates rise? I cover how to approach these questions in scenario and sensitivity analysis.
The full analysis is in the Debt Restructuring Analysis.
Frequently asked questions
Why isn’t EBITDA enough on its own?
EBITDA ignores tax, capital expenditure and working capital needs. Despite high EBITDA, these items can leave little cash for debt service.
What is the difference between interest coverage and DSCR?
Interest coverage considers only interest expense. DSCR also includes principal repayments, which gives a more realistic picture, especially for companies with a lot of short-term debt.