What is debt service?
Debt service is the money needed to cover the repayment of interest and principal debt for a given period. If a person takes out a mortgage or student loan, the borrower must calculate the annual or monthly debt service required for each loan. Likewise, businesses must meet debt service requirements for loans and bonds issued to the public. The ability to repay debt is a factor when a business needs to raise additional capital to operate the business.
Key points to remember
- Debt service is the cash required to repay the principal and interest on the outstanding debt for a given period.
- The debt service ratio is a tool used to assess the leverage of a business.
- Lenders want to know that a company is able to cover its current debt in addition to any potential new debt.
- In order to support a high level of debt, a business must generate consistent and reliable profits for debt service.
How debt service works
Before a business approaches a banker for a business loan or considers the interest rate to offer for a bond issue, the business must calculate the Debt service coverage ratio. This ratio determines the borrower’s ability to make debt service payments because it compares the company’s net operating income with the amount of capital and interest the business has to pay. . If a lender decides that a business cannot generate constant income to pay off its debt, it does not make a loan.
Lenders and bondholders are interested in the leverage of a business. This term refers to the total amount of debt a company uses to finance asset purchases. If a company takes on more debt, the company must generate higher profits in the income statement to repay the debt, and a company must be able to generate profits consistently to support a high level of debt. ABC, for example, generates excess income and can pay off more debt, but the company must generate a profit each year to cover the debt service each year.
Debt decisions affect the capital structure of an enterprise, which is the proportion of total capital raised through debt to equity. A company with consistent and reliable profits can raise more funds using debt, while a company with inconsistent profits must raise equity, such as common stocks, to raise funds. For example, utility companies have the capacity to generate constant revenue. These companies mobilize the majority of capital using debt, with less money raised by equity.
How the debt service coverage ratio is used
The debt service coverage ratio is defined as net operating income divided by total debt service, where net operating income refers to the profits generated by the normal business activities of a business. Suppose, for example, that ABC Manufacturing makes furniture and the business sells a warehouse for a profit. The income generated by the sale of warehouse is non-operating income because the transaction is unusual.
Suppose that in addition to the sale of the warehouse, operating profits totaling $ 10 million are generated by ABC furniture sales. These gains are included in the calculation of debt service. If ABC’s principal and interest owed in a year is $ 2 million, the debt service coverage ratio is ($ 10 million in revenue / $ 2 million in debt service ), or 5. The ratio indicates that ABC has a profit of $ 8 million greater than the debt service required, which means that the company can go into more debt.