What Is Debt Coverage Ratio?

The debt coverage ratio is a calculation to determine whether an asset brings in enough income to cover the costs of debt service. It is also known as the debt service coverage ratio and is a useful tool for lenders, accountants, and business administrators. To calculate the debt coverage ratio, it is necessary to divide the net operating income by the annual costs of debt service. For example, if a rental property brings in $60,000 United States Dollars (USD) annually and the cost for covering the mortgage is $40,000, the debt coverage ratio is 1.5.

Lenders want to know if a property provides enough income to cover a mortgage. This can be important for loan applications, where the applicant will need to demonstrate the ability to pay the loan with the income from the property, and for activities like refinancing. If the debt coverage ratio is less than one, it means that the property is not generating enough income to pay the loan. Hovering right around one is also not ideal, as it leaves very little margin for error; if the owner needs to replace the roof, for example, this could make it impossible to service the loan.

Companies must consider the debt coverage ratio when making financial decisions. A company carrying copious amounts of debt might have a low or even negative ratio and will put itself at risk. It can attempt to refinance or consolidate debt to make the debt service less costly, or may need to turn to investors to add capital and stabilize its financial situation. Companies under consideration for mergers and acquisitions usually need to show a healthy debt coverage ratio so prospective buyers know the investment would be sound.

Investment real estate is the field where this issue most commonly arises. Investors looking at the purchase of real estate must consider how much net income they can anticipate, looking at the amount of rent they can reasonably charge and subtracting costs like insurance, maintenance, staffing, and so forth to determine the net operating income. With this information in hand, they can look at properties with loans that will have annual payments less than this amount. The bigger the ratio, the better chance of making a profit.

Debt coverage ratio can also be a concern with personal finances. When personal expenditures and debts outstrip income, the debt coverage ratio can turn negative. The individual consumer will quickly end up in financial trouble because he needs to take out more loans to meet needs, and cannot pay them off because he's already servicing existing loans.