In corporate finance, debt coverage ratio means the cash flow available to meet principle, interest and lease payments. In personal finance, it is the formula that loan officers use to determine the borrower’s ability to pay back the debt.
The basic formula used is DSCR = (Annual Net Income + Amortization/Depreciation + Interest Expense + other non-cash and discretionary items (such as non-contractual management bonuses)) / (Principal Repayment + Interest payments + Lease payments
For example, Mrs. Sanchez wants to purchase a cafe with a net operating income of $50,000 and an annual debt service of $25,000. This gives her a debt coverage ratio of 2, which is well over the 1.15-1.35 debt coverage ratio banks like to see. When the number is less than 1, it is considered negative cash flow.