What is Debt Service in personal and corporate finance?
How do you calculate debt service?
What are the essential elements you should know!
In this article, we will break down the financial definition of Debt Service so you know all there is to know about it!
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What Is Debt Service
Debt service is a financial term referring to the amount of money or cash required to pay capital and interest on debt during a specific period of time.
For example, if a company borrows money from a financial institution, it must calculate how much it must repay in interest and principal on a monthly or annual basis.
The company must calculate the monthly or annual debt service to ensure that it dedicates enough cash reserves to cover its loans, mortgages, or other types of debt.
A company’s decision on how much debt to carry on its balance sheet will directly impact the company’s capital structure representing the total capital raised through debt vs equity.
Typically, you can expect to see a company with strong cash flows and consistent profits to be able to raise capital using debt without having to issue equity securities.
The advantage is that the company does not dilute its shareholders’ percent ownership in the company but the downside is that the company will need to allocate a fixed amount of cash to service its debt.
On the other hand, a company without a demonstrated history of consistent income and profits may need to rely more on raising capital through the issuance of equity securities such as common stock or preferred stock to investors.
A person or company who is able to pay off its debt on time will have a good “credit score” thereby increasing its reputation before lenders.
If an individual or business is unable to pay its debt on time or defaults on payments, then not only will its credit score go down but also other lenders may be less likely to issue debt or may charge a much higher rate of interest.
Debt Service Definition
According to Corporate Finance Institute, debt service is defined as:
Debt service refers to the total cash required by a company or individual to pay back all debt obligations.
In other words, it’s the amount of money a person or company needs to pay its monthly or annual loan payments to all its lenders.
For example, if a person takes on a mortgage to buy a house and takes a personal loan to buy a car and a consumer loan to buy furniture, the debt service is the total amount the consumer is required to pay to cover its mortgage payments, car payments, and consumer loan payments.
How Debt Services Work
Creditors funding companies through debt, such as banks, lenders, and bondholders, will consider a company’s ability to cover all its debt payments before deciding to lend further.
A company using debt instruments to finance its operations is said to be a “leveraged company”.
Total debt services is a measure of how extensively a company is leveraged or relying on debt to finance its operations.
In other words, how heavily is a company using debt to purchase assets or run its business.
If a company takes on debt to finance its operations, it must therefore generate more revenues and higher profits to be able to meet its loan payments or “service” the debt on its balance sheet.
On the other hand, a company unable to increase its overall profitability will see its capacity to pay off debt adversely affected thereby signaling lenders that granting further debt to this company may be more risky.
There are instances when lenders may agree to offer debt financing to a company provided the company maintains a debt service reserve account (DSRA) providing assurance to the lender that it will ensure it keeps sufficient funds on its books to assume future payment obligations.
How To Calculate Debt Service Coverage Ratio
The total debt servicing ratio or debt service coverage ratio is a measurement of a company’s ability to cover its debt load.
Here is how to calculate the debt service coverage ratio:
Debt Service Coverage Ratio = Net Operating Income / Total Debt Service
Net Operating Income = Revenue – Certain Operating Expenses
As you can see from the above formulas, the serviceable debt ratio compares the company’s net operating income with the principal and interest the firm or company is required to pay on debt.
A company can obtain additional loans or seek debt financing by having a ratio that fits within the parameters and “comfort” of the lenders.
A company having a strong and consistent cash flow can expect to have a better ability to cover its debt than another company.
Debt Service Example
Let’s look at an example of how to calculate annual debt service and how the debt service coverage ratio is used in practice.
Let’s assume that Company ABC sells consumer goods generating $100 million every year (this is the company’s net operating income).
Let’s also assume that the company has borrowed money from the bank and must repay principal and interest of $5 million this year.
The company’s debt service is $5 million.
The debt service coverage ratio (DSCR) is the company’s operating income divided by its total debt service for the year ($100M / $5M = 20).
The company’s DSCR is 20.
From a lender’s perspective, this company can easily absorb more debt on its balance sheet because it has more than enough operating income to cover its debt.
The company has $95 million in earnings over and above what it needs to pay in debt to its lenders.
Let’s look at the reverse situation, let’s assume the company had $5 million in operating income and $100 million in debt service payments to make this year.
The company’s DSCR would have resulted in 0.05.
This ratio should be extremely troubling for the company and lenders as it shows that the company barely has any operating income to cover its debt.
Debt Servicing Takeaways
So, what is annual debt service?
How to calculate debt service?
Let’s look at a summary of our findings.
Define Debt Service
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