# 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:

- Horizontal and Vertical Analysis
- Ratios Analysis
- Horizontal Analysis or Trend Analysis
- Trend Percentage
- Vertical Analysis
- Accounting Ratios Definition, Advantages, Classification and Limitations:
- Gross profit ratio
- Net profit ratio
- Operating ratio
- Expense ratio
- Return on shareholders investment or net worth
- Return on equity capital
- Return on capital employed (ROCE) Ratio
- Dividend yield ratio
- Dividend payout ratio
- Earnings Per Share (EPS) Ratio
- Price earning ratio
- Current ratio
- Liquid/Acid test/Quick ratio
- Inventory/Stock turnover ratio
- Debtors/Receivables turnover ratio
- Average collection period
- Creditors/Payable turnover ratio
- Working capital turnover ratio
- Fixed assets turnover ratio
- Over and under trading
- Debt-to-equity ratio
- Proprietary or Equity ratio
- Ratio of fixed assets to shareholders funds
- Ratio of current assets to shareholders funds
- Interest coverage ratio
- Capital gearing ratio
- Over and under capitalization
- Financial-Accounting- Ratios Formulas
- Limitations of Financial Statement Analysis

### Other Related Accounting Articles:

- Fixed Assets Turnover Ratio
- Current Assets to Proprietor’s Fund Ratio
- Financial Accounting Ratios & Formulas
- Fixed Assets to Proprietor’s Fund Ratio
- Return on Shareholders Investment or Net Worth Ratio
- Proprietary Ratio or Equity Ratio
- Over and Under Trading
- Return on Equity Capital (ROEC) Ratio
- Dividend Yield Ratio
- Operating Ratio

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