Which ratio is commonly used to measure covenant risk due to leverage?

• A. Return on assets.
• B. Debt service coverage ratio (DSCR).
• C. Quick ratio.
• D. Gross margin.

Answer: (B)

Understanding covenant risk from leverage means assessing whether a borrower can meet debt payments with the cash flow the business generates. The debt service coverage ratio does exactly that: it compares the cash flow available to service debt to the actual debt payments due in the period. A higher DSCR means a bigger cushion to cover those payments, while a DSCR below one signals a real risk of missing obligations, which is at the heart of leverage covenants. Lenders commonly use minimum DSCR covenants to ensure the borrower can sustain debt payments even if earnings fluctuate, making this ratio the most direct measure of covenant risk tied to leverage. Other ratios don’t directly focus on debt service: return on assets measures profitability relative to assets, the quick ratio looks at short-term liquidity, and gross margin reflects operating profitability, none of which pin down the ability to cover debt obligations.