The formula for debt coverage ratio is net operating income divided by debt service. The debt coverage ratio is used in banking to determine a companies ability to generate enough income in its operations to cover the expense of a debt. On a broader level, it may also be used internally by a company for the same reason.
A company's net operating income is its revenues minus its operating expenses. For comparison, a company's net income considers interest expenses on debt, taxes, and income not earned in its natural operations.
A company's net operating income can be found on its income statement.
Example of Debt Coverage Ratio Formula
An example of the debt coverage ratio would be a company that shows on its income statement an operating income of $200,000. The debt payments for the same period is $35,000. By dividing the $200,000 by $35,000, the company would show a debt coverage ratio of 5.71.
Use of the Debt Coverage Ratio Formula
As stated in a prior section, the debt coverage ratio may be used internally by a company to determine its ability to cover payments on its debt. The debt coverage ratio may also be used in lending by financial institutions for the same reason.
In lending, a financial institution will generally have various metrics to determine a borrower's ability to meet the debt. This applies to business and consumer loans. The debt coverage ratio could be considered, in a very broad sense, to be an inverse of the debt to income ratio used in consumer loans as it is income divided by debt payments. This is not to be taken literally as there are differences.
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