What is Debt Service?
Debt service refers to the funds necessary to cover the payment of interest and principal on a loan or other debt over a specified time period. This term applies to both individual debts, such as a home mortgage or a student loan, and larger corporate or government debts like business loans and bonds.
The ability to service debt is a critical factor when individuals apply for loans or businesses seek additional capital to sustain operations. ‘Servicing a debt’ essentially means making the required payments on it.
Key Takeaways
- Financial Commitment: Debt service signifies the money required to pay the principal and interest on a debt within a designated period.
- Debt Service Ratio: This is an important tool for assessing a company’s leverage.
- Lender Confidence: Potential lenders or bond buyers evaluate a company’s ability to manage new debt on top of its existing obligations.
- Profit Consistency: High debt burdens require businesses to consistently generate reliable profits.
How Debt Service Works in Business
Before a company secures a commercial loan or sets the interest rate on a new bond issue, consideration of the debt-service coverage ratio (DSCR) is critical. This ratio compares the company’s net operating income with the amount of principal and interest due on existing debts. If lenders believe that a business cannot generate consistent earnings to service both new and existing debts, they will likely withhold loan approval.
Lenders and bond investors focus on a company’s leverage, reflecting the total debt utilized for financing asset purchases. Businesses aiming to take on more debt need to amplify profits to manage this burden, maintaining earnings stability is crucial. Companies generating excess earnings might service additional debt, but they need to produce profits each year sufficient to cover the annual debt service. Overleveraging occurs when a company assumes too much debt relative to its income.
Debt decisions influence a company’s capital structure, representing the proportion of total capital raised via debt versus equity (e.g., selling shares). Firms with reliable earnings can use debt to raise funds more than those with fluctuating profits, which may issue equity such as common stock.
For example, utility companies often generate consistent earnings due to limited competition, mainly raising capital through debt rather than equity.
Example of a Debt-Service Coverage Ratio Calculation
The debt-service coverage ratio is calculated by dividing net operating income by total debt service. Only earnings generated from standard business operations count as net operating income.
Imagine ABC Manufacturing, a furniture producer, selling a warehouse for a profit. This would be considered non-operating income, as it’s a rare transaction.
Assuming ABC’s furniture sales yield an annual net operating income of $10 million, this figure is used in the debt service calculation. With $2 million in principal and interest payments for the year, ABC’s debt-service coverage ratio would be 5 ($10 million / $2 million). This high ratio implies ABC is well-positioned to manage additional debt.
What is a Good Debt-Service Coverage Ratio?
Generally, the higher the ratio, the better. Business lenders typically seek a ratio of at least 1.25.
A debt-service ratio of 1 indicates that a company allocates all its net income to debt payments, an extremely risky stance that likely prevents further borrowing.
Companies with a ratio below 1 spend more on debt servicing than their income statements support, potentially leading to business failure.
What is a Debt-to-Income (DTI) Ratio?
A debt-to-income (DTI) ratio helps evaluate an individual’s ability to service their debt, calculated by dividing gross income by total debt obligations within the same time period.
For example, someone earning $5,000 monthly paying $2,000 towards their mortgage has a DTI of 40%. Acceptable DTI ratios vary among lenders and loan types.
Is Loan Servicing the Same as Debt Servicing?
Although similar, loan servicing and debt servicing are different. Loan servicing encompasses administrative tasks performed by lenders or third-party companies, such as sending monthly statements and processing payments. Debt servicing involves borrowers paying down a loan or other debt.
The Bottom Line
Debt service concerns the funds a person, business, or government needs to cover loan or debt payments over a specific period. A company’s debt-service coverage ratio gauges its ability to manage additional debt by comparing available income with current debt servicing expenses.
Related Terms: Loan Service, Debt-to-Income Ratio, Net Operating Income, Leverage.
References
- Consumer Financial Protection Bureau. “What Is a Debt-to-Income Ratio?”
- Consumer Financial Protection Bureau. “What’s the Difference Between a Mortgage Lender and a Servicer?”
