Debt Service Ratio or Interest Coverage Ratio


Debt Service Ratio or Interest Coverage Ratio:

Definition:

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

Example:

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

Calculation:

Interest Coverage Ratio = (75,000* + 75,000* + 10,000) / 10,000

= 16 times

*Income after interest is $7,5000 + income tax $75,000

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.

You may also be interested in other articles from “financial statement analysis” chapter:

  1. Horizontal and Vertical Analysis
  2. Ratios Analysis
  3. Horizontal Analysis or Trend Analysis
  4. Trend Percentage
  5. Vertical Analysis
  6. Accounting Ratios Definition, Advantages, Classification and Limitations:
  7. Gross profit ratio
  8. Net profit ratio
  9. Operating ratio
  10. Expense ratio
  11. Return on shareholders investment or net worth
  12. Return on equity capital
  13. Return on capital employed (ROCE) Ratio
  14. Dividend yield ratio
  15. Dividend payout ratio
  16. Earnings Per Share (EPS) Ratio
  17. Price earning ratio
  18. Current ratio
  19. Liquid/Acid test/Quick ratio
  20. Inventory/Stock turnover ratio
  21. Debtors/Receivables turnover ratio
  22. Average collection period
  23. Creditors/Payable turnover ratio
  24. Working capital turnover ratio
  25. Fixed assets turnover ratio
  26. Over and under trading
  27. Debt-to-equity ratio
  28. Proprietary or Equity ratio
  29. Ratio of fixed assets to shareholders funds
  30. Ratio of current assets to shareholders funds
  31. Interest coverage ratio
  32. Capital gearing ratio
  33. Over and under capitalization
  34. Financial-Accounting- Ratios Formulas
  35. Limitations of Financial Statement Analysis

Other Related Accounting Articles:

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