What is debt service?
Debt service refers to the money needed to cover the payment of interest and principal on a loan or other debt for a given period. The term can apply to both individual debt, such as a mortgage or student loan, and corporate or government debt, such as business loans and debt securities, such as bonds. Ability to service debt is a key factor when someone applies for a loan or a business needs to raise additional funds Capital city to operate his business. “Service of a debt” means making the necessary payments thereon.
Key points to remember
- Debt service refers to the money needed to pay the principal and interest on an outstanding debt for a given period.
- The debt service ratio is a tool used to measure a company’s indebtedness.
- Potential lenders or bond buyers want to know that a company will be able to cover any new debt in addition to its current debt.
- In order to sustain high indebtedness, a business must generate consistent and reliable profits to service its debts.
How corporate debt service works
Before a business approaches a bank or other lender for a business loan or decides what interest rate offer on a new bond issue, it will have to take into account its debt service coverage ratio (DSCR). This ratio compares the company net operating income with the amount of principal and interest it is required to pay on its current debts. If a lender decides that a business cannot generate consistent revenue to pay off new debt in addition to its existing debts, the lender will not make the loan.
Lenders and bond investors are interested in leverage. This refers to the total amount of debt a company uses to fund asset purchases. If a company intends to take on more debt, it must generate higher profits to service the debt, and it must be able to regularly generate profits to support high debt. A company that generates excess profits may be able to pay off additional debt, but it must continue to produce enough profit each year to cover the year’s debt service. A company that has taken on too much debt in relation to its income is said to over-indebted.
Debt decisions affect the capital structurewhich is the proportion of total capital raised by borrowing vs. equity (i.e. sell shares). A company with consistent and reliable profits can raise more funds using debt, while a company with inconsistent profits must issue stock, such as ordinary actions, to raise funds. For example, utility companies have the ability to generate consistent profits, in part because they often have no competitors. These companies raise the majority of their capital using debt, a lower portion of capital.
Example of Debt Service Coverage Ratio Calculation
As mentioned, the debt service coverage ratio is defined as net operating income divided by total debt service. Net operating income refers only to profits generated from a company’s normal business activities.
Suppose, for example, that ABC Manufacturing manufactures furniture and sells one of its warehouses for a profit. The profit he derives from the warehouse sale is non-operating result because the transaction is unusual.
If ABC’s furniture sales produced annual net operating income totaling $10 million, that is the figure that would be used in the debt service calculation. So if ABC’s principal and interest payments for the year total $2 million, its debt service coverage ratio would be 5 ($10 million in revenue divided by $2 million in debt servicing). Because of this relatively high ratio, ABC is in a good position to take on more debt if it chooses.
What is a good debt service coverage ratio?
Generally speaking, the higher the better. But commercial lenders will generally want to see a ratio of at least 1.25.
A debt-service ratio of 1, for example, means a company is spending all of its available income on paying down debt – a precarious position that would likely make further borrowing impossible.
Businesses can also have a debt service coverage ratio of less than 1, which means it costs them more to service their debt than they generate revenue. However, a business in this situation might not survive for long.
What is a debt to income ratio?
A debt-to-income ratio (DTI) is similar to a debt service coverage ratio, although it is generally used for personal (non-commercial) borrowing. The DTI ratio measures an individual’s ability to repay their debts by dividing their gross income by their debts for the same period. For example, someone who earns $5,000 per month and pays $2,000 per month on their mortgage will have a DTI of 40%. An acceptable DTI will vary from lender to lender and by type of loan product.
Is loan servicing the same as debt servicing?
Although they look alike, loan service and debt servicing are two different things. Loan servicing refers to the administrative work performed by lenders or other companies they hire, such as sending monthly statements to borrowers and processing their payments. Debt service refers to the process by which a borrower pays off a loan or other debt.
Debt service refers to the money a person, business or government needs to cover the payments of a loan or other debt for a given period. A company’s debt service coverage ratio measures its ability to handle additional debt by comparing its disposable income to the amount it is currently paying to service its debt.