DSCR explained: the ratio every term loan rests on
When a business asks for a term loan, the first question a credit manager asks is simple: will this business earn enough cash to pay the instalments? The debt service coverage ratio, or DSCR, is how that question is answered in numbers.
What DSCR measures
DSCR compares the cash a business generates in a year with the debt it has to service in that year.
DSCR = (PAT + Depreciation + Interest on term loan) ÷ (Interest on term loan + Principal repayment)
Each piece has a reason:
- PAT (profit after tax) is what the business earns after all expenses and tax.
- Depreciation is added back because it's an accounting charge, not cash going out.
- Interest on term loan is added back because it was deducted to arrive at PAT, yet it's paid out of the same cash. It then appears in the denominator as part of the debt service.
- The denominator is the actual debt service for the year: interest plus the principal instalments due.
A DSCR of 1 means the business earns exactly enough to pay its instalments, with nothing to spare.
A worked example
Say a business reports:
| Item | ₹ lakh |
|---|---|
| Net profit after tax | 18.0 |
| Depreciation | 6.0 |
| Interest on term loan | 4.5 |
| Principal due this year | 12.0 |
Cash available for debt service = 18 + 6 + 4.5 = 28.5 lakh. Debt service due = 4.5 + 12 = 16.5 lakh. DSCR = 28.5 ÷ 16.5 = 1.73.
For every rupee due to the bank this year, the business generates ₹1.73. That's a comfortable cushion.
What level do banks look for?
There's no single rule, and norms vary by bank, sector and loan type. As a working guide, many lenders look for an average DSCR of around 1.25 or more over the loan tenure. Below 1.0 means the business can't meet its instalments from its own earnings.
Two numbers matter more than one:
- The average DSCR across all years of the loan.
- The lowest DSCR in any single year. A healthy average can hide one weak year, often the first year after a moratorium ends or a year with a large balloon repayment.
Where DSCR calculations go wrong
These are the mistakes I saw most often at the credit desk:
- Leaving out other loans. The denominator must include instalments on all term debt, including vehicle loans, existing term loans and loans from other banks.
- Over-optimistic projections. A DSCR built on 30% sales growth every year isn't an assessment. Test it against the business's actual past growth.
- One-off income in PAT. Profit from selling an asset or a one-time subsidy inflates the numerator for one year only.
- Ignoring the repayment schedule. If the schedule has a moratorium, the first full repayment year usually has the lowest DSCR. Check that year specifically.
How a weak DSCR can be fixed
If the numbers don't work, the structure can sometimes be changed rather than rejecting the proposal outright:
- Longer tenure spreads the principal and lowers the annual debt service.
- A suitable moratorium gives a new project time to start earning.
- More promoter contribution reduces the loan amount itself.
- A realistic repayment schedule that matches the business's cash flow cycle.
What shouldn't change are the assumptions. If a DSCR only works after the projections are pushed up, the business can't really afford the loan.
All content is for educational purposes only and isn't financial or investment advice.
