Debt service coverage: the ratio that pays the loan
One ratio carries the whole repayment question — which is why the definition matters more than the number.
The concept
Debt service coverage is cash available for debt service divided by the debt service owed. The idea is old; the fights are all in the definitions. Which cash counts — reported EBITDA, normalized earnings, or cash flow after maintenance capital spending and taxes? Which obligations count — scheduled principal plus interest, the current portion of long-term debt, the operating line’s interest, CSBFP amortization?
Each institution writes its own formula into credit policy, and the policy floor — often 1.25 times on conventional commercial term debt — only means something relative to that formula. A 1.4 computed on EBITDA over scheduled principal is not the same coverage as 1.4 computed on post-distribution cash flow. Two lenders quoting the same number may be saying different things about the same borrower.
The current portion of long-term debt is the denominator’s trap. Compilation and notice-to-reader statements — the paper most small Canadian borrowers produce — often do not separate it. The analyst must reconstruct it from the loan schedules and the amortization table, or the ratio reads better than the truth.
What a lender asks of it
- Whose definition
- The institution’s formula is the one that binds. The borrower’s accountant will offer a friendlier number; both should be in the file.
- What sits in the denominator
- Balloon payments, the margined line treated as long-term or short, the new CSBFP loan the statements predate — each omission flatters the ratio.
- Which earnings year
- A single year lies for tax timing, one-time items and owner draws. The trend across three years, and the reason the worst year was worst, carries more than the average.
- Distributions in or out
- Whether owner draws reduce the numerator before coverage is tested decides many small-business files. Policy says where the line sits; the memo says why.
Where files get it wrong
- Computing coverage on net income — accrual earnings are not the cash the lender gets paid with.
- Missing the current portion of term debt because the compilation did not show it, then approving coverage that does not exist.
- Averaging three years to hide the year the ratio broke.
- Leaving the operating line out of debt service while the borrower lives on it year-round.
Training that covers it
- CA-104
- Cash flow and repayment capacity I — the module that builds the numerator honestly before the ratio is quoted.
- CA-201
- Cash flow II adds forecasts and sensitivity: coverage under the bad year, not the average one.
- TT-04
- The repayment-capacity reasoning card — the checklist version of this page, kept beside the spread template.
What is missing today
The repayment-capacity modules are written as specifications. Nothing here assigns a learner yet.