Debt Service Ratio or Interest Coverage Ratio:
Interest coverage ratio is also known as
debt service ratio
or debt service coverage ratio.
This ratio relates the fixed interest charges to
the income earned by the business. It indicates whether the business has earned
sufficient profits to pay periodically the interest charges. It is calculated by
using the following formula.
Formula of Debt Service Ratio or interest coverage ratio :
Interest Coverage Ratio = Net
Profit Before Interest and Tax / Fixed Interest Charges
If the net profit (after taxes) of
a firm is $75,000 and its fixed interest charges on long-term borrowings are
$10,000. The rate of income tax is 50%.
Calculate debt service ratio / interest coverage ratio
Interest Coverage Ratio = (75,000* + 75,000* + 10,000) /
= 16 times
*Income after interest is $7,5000 + income tax
Significance of debt service ratio:
The interest coverage ratio is very important from the lender's point of
view. It indicates the number of times interest is covered by the profits
available to pay interest charges.
It is an
index of the financial strength of an enterprise. A high debt service ratio
or interest coverage ratio assures the
lenders a regular and periodical interest income. But the weakness of the
ratio may create some problems to the financial manager in raising funds
from debt sources.