The debt coverage formula ratio describes a company’s ability to generate enough net operating income to cover the expense of debt. The higher the ratio, the easier is to service the debt. Debt coverage ratio can be used to analyse companies, projects, or individual borrowers.

How to calculate debt coverage?

Debt coverage is calculated by dividing net operating income by total debt service.

Debt\;Coverage\;Formula = \frac{ Net\;Operating\;Income }{Debt\;Service}

Net operating income is a company’s or a person’s gross income minus vacancy amounts and operating expenses. It is also can be calculated as a sum of net income, depreciation, interest expense and other non-cash items. A company’s net operating income (NOI) can be found on the income statement.

NOI = Gross\;Income - Operating\;Expenses

Net income is a total income minus expenses, cost of sold goods and taxes.

  • Gross income is the total amount of money earned.
  • Vacancy expenses is the cost that occurs when investment property is not used over a certain period of time.
  • Other income is income that does not come from a company’s main business.
  • Operating expenses are all the expenses associated with the company’s main operating activities.

Total debt service is a total amount of cash required to cover the repayment of the interest and principal on a debt. Total debt service also includes lease payments and can be presented as:

Total\;Debt\;Service = Interest\;Payments + Principal\;Payments + Lease\;Payments
  • Interest payment is a payment that borrower pays to a lender for borrowing funds. It is also payments associated with investments, for example, dividends.
  • Principal payment refers to the initial size of a loan.
  • Lease payment is an equivalent of a rent payment when a company or a person uses real estate, equipment, vehicles or any other asset for a fixed amount of time for a fixed payment.

Debt coverage explained

  • Debt coverage < 1. Debt coverage ratio below 1 means that a company or a person does not generate enough income to cover the loan payments. For example, debt coverage of 0.8 that a company generates only $0.8 of net income to cover $1 of debt.
  • Debt coverage = 1. In theory, if the debt ratio is 1, that means that a company generates exactly as much profit, as needed to pay its debt obligations. However, in practice, most commercial banks require a debt coverage ratio of more than 1.
  • Debt coverage > 1. Debt coverage ratio greater than 1 means that a property generates more income, than its total debt payments. Most banks require debt coverage ratio of 1.15-1.35. For example, debt coverage ratio of 1.25 ensures that a property generates $1.25 of income for each $1 of debt.

Example of debt coverage calculation

  • A company shows $1,000,000 of net operating income on its income statement.
  • The debt payment for this year is $600,000.
Debt\;Coverage = \frac{\$1,000,000}{\$600,000} = 1.67

That means that this company generates 67% more than is required to pay the annual debt payment.

Debt coverage and capital structure

Decisions about debt have an impact on a company’s capital structure. Companies with a higher debt are considered to be riskier and less stable. Having a high level of debt involves the risk of insolvency, i.e. an excessively indebted company, at some point may lose its ability to pay back the borrowed funds.

Debt financing also involves additional costs, which are usually higher than costs related to shareholders’ capital. However, companies with higher debt can get additional benefits of using financial leverage.  Financial leverage allows the company to achieve above-average incomes by partly financing its activities with borrowed capital.

For example, a company can purchase an asset or invest in a new project by using borrowed funds, and the rate of return from these investments will be higher than borrowing cost.