DSCR: The Ratio That Decides How Much a Bank Will Lend
- How it is computed
- A worked example
- Now add one new loan
- What banks do with the number
- Four ways to improve DSCR without faking anything
- Checking your own capacity before you apply
- Where this fits
The debt service coverage ratio, or DSCR, compares the cash a business generates with the loan repayments it has to make in the same year. A DSCR of 2.0 means the business earns twice what it needs to service its debt. A DSCR below 1.0 means it cannot pay its lenders out of operations at all.
For term loans it is usually the ratio that sets the ceiling. Leverage ratios such as TOL/TNW tell a bank how much of the business is funded by outsiders. DSCR tells it whether the business can actually pay.
How it is computed
Lenders vary slightly in their definitions, so always ask for the one your bank uses. The version most commonly seen in Indian credit appraisal for term loans is:
DSCR = (Profit after tax + Depreciation + Interest on term loans) ÷ (Interest on term loans + Principal repaid on term loans)
The numerator approximates the cash available to service debt. Depreciation is added back because it is a non-cash charge. Interest is added back because it is one of the things being paid out of that cash.
The denominator is the full debt service for the year: interest and the principal instalments falling due.
Two points often missed. Working capital interest, on a cash credit or overdraft, is usually treated as an operating cost and left in, while term loan interest and principal go into the ratio. And the principal is the scheduled repayment in that year, not the outstanding balance.
A worked example
A packaging manufacturer’s last full year:
| Item | ₹ |
|---|---|
| Profit after tax | 18,00,000 |
| Depreciation | 6,00,000 |
| Interest on existing term loan | 4,00,000 |
| Principal repaid on existing term loan | 10,00,000 |
Numerator: 18,00,000 + 6,00,000 + 4,00,000 = ₹28,00,000.
Denominator: 4,00,000 + 10,00,000 = ₹14,00,000.
DSCR = 28,00,000 ÷ 14,00,000 = 2.00. Comfortable by almost any standard.
Now add one new loan
The owner wants ₹30 lakh for a second machine, over five years at 11% a year with monthly instalments. The EMI works out to about ₹65,227.
In the first year those twelve instalments contain about ₹3,06,000 of interest and ₹4,76,000 of principal: ₹7,83,000 of new debt service.
For the appraisal, assume the machine earns nothing extra in year one. Profit falls by the new interest, but interest is added back in the numerator, so ignoring tax the numerator stays at ₹28,00,000.
The denominator rises to 14,00,000 + 7,83,000 = ₹21,83,000.
DSCR = 28,00,000 ÷ 21,83,000 = 1.28.
One loan, sized at less than two years’ profit, took the ratio from 2.00 to 1.28. That is why owners are often surprised to be offered less than they asked for. The business did not get riskier; its annual repayment burden rose by more than half, from ₹14 lakh to about ₹21.8 lakh, against the same cash.
Tax is ignored in this step for clarity. In practice interest reduces taxable profit, so the fall in profit after tax is smaller than the interest itself, which nudges the ratio slightly higher than 1.28.
What banks do with the number
Each lender sets its own minimum in its credit policy, and it can vary by sector, security and the size of the exposure. Ask what it is before you apply. As an illustration only, if the threshold were 1.25, this business would just pass, with almost no room for a bad year.
Banks rarely look at one year. For a new term loan they usually ask for projected DSCR for every year of the loan, and look at the average and the lowest year. A project that shows 1.1 in year one and 2.5 in year four has a problem in year one regardless of the average.
That is also the honest way to present your own proposal: if the new machine will add ₹8 lakh of profit from year two, show it year by year, and show what happens if it adds only half that.
Four ways to improve DSCR without faking anything
- Lengthen the tenure. The same ₹30 lakh over seven years instead of five cuts annual principal and lifts the ratio. You pay more interest in total, so this is a trade-off, not a free improvement.
- Ask for a moratorium on principal during the period before the new asset earns. Many term loans for plant and machinery are structured this way, and it matches repayment to cash flow.
- Put in more of your own money. A smaller loan means a smaller denominator. A higher promoter contribution also improves every leverage ratio at the same time.
- Refinance or prepay expensive small loans first. Short vehicle loans and unsecured business loans carry large principal instalments relative to their size, and they sit in the denominator of every future application.
What does not work is inflating the projections. Banks compare projected figures with your filed financial statements and GST turnover, and a proposal that assumes growth the history does not support gets discounted, if not declined.
Checking your own capacity before you apply
Take last year’s audited figures, compute DSCR on existing debt, then add the EMI of the loan you want and recompute. If the answer is uncomfortably close to your lender’s minimum, you already know the likely outcome and you have time to change the tenure, the amount or the timing before an application is on record.
Where this fits
- The leverage side of the same appraisal: TOL/TNW ratio
- Other ratios worth computing: financial ratios worth computing
- Test the EMI and eligibility: EMI calculator · loan eligibility calculator
- Funding choices before borrowing: debt vs equity funding