The debt service coverage ratio determines if a company’s revenues can cover its obligations. To calculate this ratio, line items from a corporation’s income statement are used. Let’s take a look at the formula:
If you recall from the first fundamental analysis section, net operating income is gross income (profit) minus operating expenses. Debt service represents the amount of money that a company must pay on outstanding loans. It’s best to have a debt service coverage ratio comfortably above 1, as this would demonstrate more revenues received than payouts made. The lower the debt service coverage ratio, the more likely it is that a company will have trouble paying its debts.
If you’re already in the industry, you may know that there are other versions of the DSCR formula that are used more commonly in “real-world” situations. Even so, FINRA takes a simplified stance for the Series 7 exam. Whichever DSCR formula you use, it’s important to remember expenses must be deducted from income.
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