Which ratio best reflects a borrower's ability to service debt from operations?

• A. Debt Service Coverage Ratio
• B. Current Ratio
• C. Quick Ratio
• D. Gross Margin

Answer: (A)

Debt service capacity from operations is best shown by the Debt Service Coverage Ratio. It directly compares the cash flow a borrower generates from operations to the annual debt payments they must make (principal and interest). When the ratio is above 1, there’s enough cash flow to cover debt service; below 1, cash flow falls short, signaling higher repayment risk. This focus on cash flow available to meet debt obligations is exactly what lenders want to assess when evaluating repayment ability. In practice, the numerator is typically net operating income or EBITDA, representing cash-generating capability, while the denominator is total annual debt service. For example, if NOI is 200,000 and annual debt service is 150,000, the DSCR is 1.33, indicating adequate coverage. If debt service were 220,000, the DSCR would be 0.91, signaling potential trouble. Other ratios look at liquidity (current and quick ratios) or profitability (gross margin) but don’t directly measure how well operating cash flows cover debt payments, so they don’t reflect debt service capacity as precisely. Lenders often require a DSCR above a minimum threshold, commonly around 1.20–1.25, to provide a cushion.