Many people nowadays decide to get a loan for numerous purposes. Whether it be a business loan, a mortgage loan, real estate, health, or other purposes, the number of lenders increases drastically. A study has found that with each year, the debt-to-GDP ratio decreases significantly. That may be because banks nowadays offer numerous benefits and good conditions.

If you plan to get a loan from a financial institution, it is the perfect time to start learning about all the requirements you need to fulfill to receive a loan. These requirements will assure the financial institution that you will regularly make debt payments and can handle the debt obligations.

Without further ado, let’s see what the debt service ratio is and how to calculate the debt service coverage ratio.

What is the debt service ratio (DSR)?

The DSR calculates all expenses and revenues, such as monthly cash flow, debt service, principal payments, operating costs, capital expenditures, and many more, but on a monthly level.

Financial institutions use the debt service ratio to calculate your monthly gross income and see whether you can pay your debt and how much time you will need to pay off a certain amount. However, as you will see below, this ratio cannot measure your financial health and annual net operating income.

You don’t have to wait for a financial institution to measure your DSR; you can do simple calculations to see your ratio. However, you must be careful when calculating the debt service ratio because you could miss some crucial points. Before jumping to debt calculation, let’s see why the DSR is vital in the financial world.

Significance of DSR

The importance of the debt service ratio lies in risk management. The lower your DSR, the less likely you will receive a loan. Institutions will calculate whether you can handle the debt payments and not leave the institution with negative cash flow; this ratio will protect the institution from potential asset loss.

Whether you have personal finance issues or need more monthly gross income to cover the loan, you may not receive what you are asking for from the bank. Thus, it is essential to calculate your DSR before asking for a loan to see the probability of you receiving financial help.

Understand How Debt Service Ratio Works

The debt service financial ratios work by dividing your or your company’s total debt payments by monthly gross income.

When calculating your DSR, include the total monthly debt service (e.g., credit card payments, car loans, mortgages, etc.). If a company or an individual has a percentage over 36%, an institution probably won’t give them a loan due to their existing debt.

Let’s see how you can calculate your borrower’s ability to understand whether you can fulfill debt obligations.

How to Calculate Debt Service Ratio?

The formula to calculate your company’s ability to pay off debt consists of your total debt payment and monthly gross income. You can divide these two to see whether you fit the good DSR. Here’s the formula:

DSR= Total Monthly Financial Commitments/Monthly gross income

By dividing these two, you will get a precise ratio.

As mentioned above, you can use the DSR formula to calculate your ratio. For example, imagine you have three principal obligations; lease, car, and credit card payments. Once you divide the sum of your obligations by your monthly gross income, you will get a ratio in the form of a percentage.

For example, suppose you give 5,300 MYR each month for your real estate, 1,300 MYR for your car payments, and 880 MYR for your credit card payments. In that case, adding these three together will give you 7,480 MYR total monthly debt service.

On the other hand, let’s assume that your monthly gross income is around 22,000 MYR. By dividing your total debt service by your monthly gross income, you will get 0.34, or 34% DSR. Any percentage less than 36% is a good ratio.

Once you calculate your ratio, you can determine whether you have an excellent monthly financial performance and enough income to apply for a loan.

What are the limitations of DSR?

Although an excellent way to calculate whether you can take a service debt, the DSR has limitations that may prevent you or the lenders from seeing the bigger picture. For example, with these calculations, the lender can only see the current principal and interest obligations; they cannot see the future financial health of the business and the individual.

Moreover, the DSR does not consider whether you are paying off short-term or long-term debt. Thus, these calculations cannot predict your or your business’s ability to repay a loan. The DSR also accounts for certain debt obligations, such as credit card payments, but may not consider other principal repayments, such as child support and healthcare.

It also doesn’t account for everyday expenses and the cost of living, such as bills and groceries, which can significantly impact the borrower’s ability of debt payments.

What are the income sources used when calculating your DSR?

Although the DSR doesn’t include numerous expenses, there is a variety of income sources it considers. Aside from regular salary and self-employment income, you should add rental income to your DSR formula. You must include this income source to get the best results if you have rental properties and earn revenue from lease payments.

You should also include your investment income in the equation; if you have invested in stocks or bonds, you should add these income streams for a realistic percentage. Additionally, if you receive retirement, social security, child support, alimony, etc., add them to your monthly gross income. However, please bare in mind that this may vary from bank to bank. Not all banks can accept this.

As a general rule of thumb, you can use your main income, plus your side hustle, with transactions captured in your bank statement. Then, when declaring your income tax, use this formula:

Income tax + rental income with a stamped tenancy agreement and monthly rental deposited to the bank.

Your financial institution will probably have your balance sheet. Therefore, to get the most accurate DSR percentage, you should include all incomes and expenses in your formula.

What is Debt Service Coverage Ratio (DSCR)?

The debt service coverage ratio, or DSCR, calculates your annual debt service and net operating income. This equation calculates your ability to pay off debt service and interest payments, but unlike the DSR, it considers a bigger picture. By calculating the DSCR, you can predict your or your company’s financial health and see whether you can meet all your debt payments. In Malaysia, DSCR is mainly used for SME loans.

Unlike the DSR, the DSCR considers long-term and short-term loans and whether you have enough net operating income to cover another loan. This method includes more sources of income and operating expenses than its DSR counterpart. Thus, this calculation is essential for determining your loan capabilities.

How to calculate DSCR?

The DSCR formula you can use to calculate the ratio includes dividing your net operating income by your total debt service, as you can see below:

DSCR = net operating income (NOI)/ total debt service payments

Before you use this DSCR formula to calculate your company’s DSCR, get your cash flow statement, income statement, and all other financial statements for the most accurate results.

What is considered a good debt service coverage ratio (DSCR)?

Your ratio should be over 1; a DSCR greater than one is a good DSCR, while anything under one represents a high risk for the institution’s financial health. The minimum DSCR you should have is 1 (but some institutions may not give you a loan with this ratio).

Let’s understand this with an example. If you have an annual net operating income of 660,000 MYR and annual debt payments of 176,000 MYR, you will have a DSCR of around 3.75, which is a good DSCR. With this ratio, you can receive a loan for your Small or Medium Enterprise because the institutions will know you can cover your principal and interest payments annually.

On the other hand, let’s say you have a 660,000 MYR net income but 750,000 in debt obligations in the same period. You will have a 0.88 DSCR, automatically telling the lenders that you don’t have enough cash flow for efficient financial management and cannot pay your debt obligation.

Net Operating Income: What is it?

Net operating income, or NOI, calculates all income from your real estate. For example, if you have real estate for commercial purposes, you can calculate your profit using your NOI.

Also, if you generate income from renting your property, you should include it in your NOI calculations. This element plays a crucial role in the borrower’s DSCR since it is one of the main components of calculating the ratio.

Net operating income is the revenue you have before the income taxes. NOI includes all revenue you generate from your real estate and some operating expenses. You can find this element on all your cash flow statements and the company’s financial reports.

Since this element is significant in calculating the debt service coverage ratio, you should first learn how to calculate NOI to get the best and most accurate results.

Calculating Net Operating Income (NOI)

The formula you can use to calculate your net operating income is as follows:

NOI = EGI – operating expenses

To calculate your net operating income accurately, you must gather all your real estate income sources in one place. That includes rent, laundry facilities, parking spaces, a spa, etc. Once you add all of that together, subtract your expenses, such as overdue rent.

On subtracting the expenses, you will get an EGI (Effective Gross Income). When determining your EGI, you should subtract all operating expenses to calculate your NOI.

Since NOI is a crucial part of learning how to calculate DSCR, you should collect all your data and carefully perform your DSCR calculation.

Conclusion: Debt Service Ratio: The Key to Getting Your Loan Sanctioned

Two types of debt ratios are debt service ratio and debt service coverage ratio. You now know the differences between these two and why they are essential for your financial health. The debt service coverage ratio helps determine who is trustworthy enough to take a loan.

If you perform your calculations correctly, you can get clarity on how to improve your ratio and become financially stronger. Moreover, you will get an insight into what you can do to get loan approval and reach your financial goal. Once you know how to calculate debt service coverage, you will have no problem selecting and getting a suitable loan approved for yourself.