Debt Service Ratio (DSR): How to Use and Calculate It

What can the debt service ratio tell you?

In some crucial areas, the DSR provides insightful information about a company's financial situation:

• Assess financial stability: DSR gauges how well a business can pay off its debt without disrupting operations. Lenders and investors concerned with creditworthiness will find a company with a strong DSR more appealing, as it suggests financial stability and low bankruptcy risk.
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• Early warning system: Monitoring DSR over time can help identify new problems with cash flow. A declining ratio could indicate reduced profitability, increasing debt, or operational inefficiencies, allowing accountants and advisors to take early action and suggest fixes before issues worsen.
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• Benchmarking and performance analysis: DSR enables comparison with historical data and industry peers. By examining trends and cross-company benchmarks, accountants can determine how well a company manages debt compared to market norms.

Interest cover versus DSR

Although both metrics evaluate a business's debt management capabilities, their functions in financial analysis are distinct:  

• Interest cover ratio: This metric focuses on a company's ability to meet interest payments. It measures short-term liquidity by dividing earnings before interest and taxes (EBIT) by interest expenses, showing how easily a company can cover its interest costs with its operating income.
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• Debt service ratio: This metric has a more comprehensive perspective by accounting for principal and interest repayments. It is handy for long-term financial planning and lenders assessing total debt repayment capacity.

Calculation and formula

Debt service ratio formula

The debt service ratio formula follows as below:  

Debt service ratio = Total debt / (Annualised free cash flow)

Where:

• ‍Total debt: Short-term debt + long-term debt
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• ‍Annualised free cash flow: Operating cash flow minus capital expenditures and other investment outflows.

How to calculate the debt service ratio

To calculate the debt-to-service ratio accurately, follow these steps:

1. Determine total debt: Add all short-term and long-term debt obligations from the balance sheet.
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2. Calculate cash flow available: Start with operating cash flow, which reflects cash earned after paying taxes. Subtract capital expenditures and other investment-related outflows to arrive at the free cash flow, the amount of cash available to service debt.
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3. Use the debt-to-service ratio formula: Divide total debt by annualised free cash flow to obtain the debt-to-servicethe debt service ratio.

Debt service ratio calculation example

Here's an example of the debt service ratio calculation:

Company ABC financial data:

• ‍Total debt: $2,400,000
• ‍Annualised free cash flow: $1,920,000

DSR calculation: $2,400,000 / $1,920,000 = 1.25
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This means that company ABC has a DSR of 1.25, which means it would take 1.25 years to pay off all its debt if it dedicated 100% of its free cash flow to debt repayment.

Financial analysis and use

Debt service ratio and financial analysis

DSR serves multiple purposes in financial analysis.

• Financial health assessment: DSR gives accountants critical insights into cash flow adequacy and debt management efficiency. This helps identify companies with trouble repaying their debts and facilitates proactive suggestions for restructuring or refinancing.
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• Trend analysis: By analysing DSR trends over time, businesses can spot patterns that indicate improving or worsening financial health. A steadily dropping DSR could indicate poor capital allocation choices or signal operational challenges that need management attention.
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• Scenario planning: DSR makes scenario analysis easier by allowing accountants to simulate various business or economic situations. This helps assess how cash flow shifts might impact debt service capability and assist clients in preparing for possible challenges.

When to consider the interest cover ratio versus the DSR

The distinction between these ratios becomes crucial in different analytical contexts:

• Interest cover ratio: This measure is better suited for evaluating short-term debt service capacity and immediate liquidity issues. It is particularly relevant when assessing businesses with a sizable amount of interest-only debt or when fluctuations in interest rates could affect financial performance.
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• Debt service ratio: Offers a complete view of a company's ability to meet its debt obligations by accounting for principal repayments. This makes it a more reliable metric for long-term financial planning and evaluating overall debt sustainability.

Advantages and disadvantages of DSR

Advantages:

DSR offers several advantages for financial analysis:

• Comprehensive debt assessment: Compared to metrics that only look at interest coverage, the DSR gives a more complete picture of debt service capability by considering both principal and interest payments.
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• Accessibility and simplicity: The ratio is straightforward to calculate and understand, making it accessible to different stakeholders, including management, lenders, and investors across varying levels of financial understanding.
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• Easy analysis: Provides a reliable early warning signal for possible financial challenges and allows easy benchmarking and comparative analysis across companies, industries and periods.

Disadvantages

Despite its usefulness, DSR has several limitations:

• Assumes cash flow consistency: DSR is based on current-period free cash flow, assuming future periods will generate similar cash levels. If free cash flow rises or falls significantly in the future, the actual time needed to repay debt could be much shorter or longer than the ratio suggests. This makes accurate cash flow forecasting essential for meaningful DSR analysis.
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• Limited debt structure considerations: It doesn't consider factors like debt maturity schedules, refinancing risks, or the full complexity of debt, all of which can have a big influence on the actual debt service needed.
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• Market access limitations: It doesn't account for the cost of debt or a company's ability to refinance or raise capital. Due to market access or credit ratings, two companies with the same DSR may have very different levels of financial flexibility.

Lender considerations

Lenders prioritise several key aspects when evaluating DSR in credit decisions.  

• Cash flow sustainability: Lenders look for stable, predictable cash flows from core operations, not one-time gains or non-recurring items.
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• DSR trend analysis: Lenders also pay attention to the DSR trend over time. A stable or improving DSR is seen as a sign of consistent debt repayment ability, while declining ratios may raise concerns and lead to stricter terms.
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• Industry-specific factors: DSR expectations vary by industry. In cyclical industries, temporary dips might be acceptable if they align with seasonal trends. However, businesses in more stable sectors are expected to maintain consistent ratios.

What the debt service ratio informs lenders

For lenders, DSR provides insights into some critical risk factors:  

• Default risk assessment: DSR shows a borrower's ability to pay off debt with current cash flow, helping lenders assess the likelihood of default and potential loss.
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• Financial flexibility evaluation: A strong DSR indicates the borrower can absorb economic shocks, invest in growth, or manage unexpected costs without jeopardising debt payments.
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• Loan terms determinator: The debt-service ratio helps lenders set loan terms like interest rates, collateral, and contract conditions. Borrowers with strong DSRs are often qualified for better terms.

Debt service ratio — common questions

Why use EBITDA?

EBITDA (Earnings before interest, taxes, depreciation and amortisation) isn’t used directly to calculate DSR, but it’s a useful starting point for understanding a business’s cash generation.

From EBITDA, you adjust for tax payments and working capital changes to get operating cash flow. Then, subtract capital spending to arrive at free cash flow, which is the figure typically used in DSR.

Why remove cash taxes?

Cash taxes are excluded from DSR calculations since they are mandatory payments that reduce the cash available for debt service. By focusing on after-tax cash flow, DSR provides a more realistic view of a company's ability to meet its debt obligations.

Why not just use operating cash flow?

Operating cash flow is a useful indicator, but it doesn’t account for necessary cash outflows like capital expenditures. The debt service ratio uses free cash flow instead, which is derived from the cash flow statement by subtracting these reinvestment costs. This provides a clearer picture of the cash actually available to service debt.

Related ratios and metrics

Debt-to-total assets ratio

The debt-to-total assets ratio complements DSR by providing insights into a company's financial leverage and capital structure. It is calculated by dividing total debt by total assets, showing the proportion of assets financed by debt.

Debt-to-equity ratio

The debt-to-equity ratio compares total debt to shareholders' equity, helping assess a company's financial leverage and risk. By revealing the company's capital structure, it offers useful information for DSR analysis.

Earnings before interest and taxes (EBIT)

EBIT is a key indicator of operational profitability before financing costs. When used alongside DSR, it helps evaluate the company's capacity to generate enough earnings to cover debt payments.

Operating profit margin

Operating profit margin measures the percentage of revenue left over after operating costs are paid. Businesses with strong operating profit margins typically have better debt service capabilities, as they generate more cash flow per dollar of revenue.

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Final thoughts

The DSR is a core metric that helps assess a business's ability to meet its debt obligations. By becoming proficient in DSR calculation and interpretation, accounting professionals can provide more effective client advisory services, from loan preparation to debt strategy.  

DSR is essential for ongoing financial monitoring as both a risk indicator and a benchmarking tool. Understanding how lenders assess DSR, particularly in terms of cash flow quality and trends, advisors can more confidently help clients secure funding and favourable terms.