Debt Service Ratio
Chapter Thirty-Nine
Syllabus topic 4, "Combined Ratio : i) Return on capital employed (Including Long Term Borrowings) ii) Return on proprietor's Fund (Shareholders Fund and Preference Capital) iii) Return on Equity Capital iv) Dividend Payout Ratio v) Debt Service Ratio vi) Debtors Turnover vii) Creditors Turnover (Practical Question on Ratio Analysis and Du Point Analysis)"
Pages 103 to 104 of 162
In one line
The debt service ratio says how many times over the year's earnings could have paid the interest on the borrowings.
The formula
Debt service ratio = Profit before interest and tax / Interest
Expressed in times. The conventional standard is six to seven times, and a lender usually looks for at least three times.
| Element | What it is |
|---|---|
| Profit before interest and tax | The whole of the year's earnings before the lender and the government take their shares |
| Interest | The interest on long-term debt. Interest on a short-term overdraft is included where the question does not separate it |
Tax is not deducted, and the reason is exact: interest is paid before tax, so the whole pre-tax profit is available to meet it.
Worked on Sunrise
| 2026, Rs | 2027, Rs | |
|---|---|---|
| Profit before interest and tax | 3,00,000 | 3,80,000 |
| Interest on debentures | 40,000 | 40,000 |
| 2026 | 2027 | |
|---|---|---|
| Debt service ratio | 7.50 times | 9.50 times |
Interpretation
Sunrise's earnings covered its interest nine and a half times in 2027, up from seven and a half. That is very comfortable: profit before interest and tax could fall by almost 90 per cent before the interest became unpayable.
Say it that way. "Nine and a half times" is a number; "the profit could fall by 89 per cent and still cover the interest" is an interpretation, and it is the same arithmetic.
| Rs | |
|---|---|
| Profit before interest and tax | 3,80,000 |
| Interest | 40,000 |
| Margin of safety | 3,40,000 |
A margin of Rs 3,40,000 on a required Rs 40,000.
What the level means
| Debt service ratio | Usually means |
|---|---|
| Below 2 times | Dangerous; a small fall in profit makes the interest unpayable, and a lender will refuse |
| 2 to 3 times | Thin |
| 6 to 7 times | Conventionally satisfactory |
| Very high | Safe, but often means the company has borrowed very little and is not using cheap finance |
The last row connects to the gearing chapter. Sunrise's 9.50 times and its debt equity ratio of 0.27 to 1 say the same thing twice: there is a great deal of room to borrow more.
The fuller version
Interest is not the only obligation on a borrowing. Where a question gives the repayment instalment as well, the fuller ratio is asked.
Debt service coverage ratio = (Profit after tax + Interest + Depreciation) / (Interest + Instalment of principal)
Three changes from the simple ratio, and each has a reason.
| Change | Why |
|---|---|
| Add back depreciation | It is a charge against profit that takes no cash out, and the instalment is paid in cash |
| Include the principal instalment | Because it too must be paid, and out of the same earnings |
| Start from profit after tax | Because the principal is repaid out of taxed profit, unlike the interest |
The rest of this chapter
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The rest of this subject
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