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.

 

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