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:

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