What is 'Debt Service'

Debt service is the cash that is required to cover the repayment of interest and principal on a debt for a particular period. If an individual is taking out a mortgage or a student loan, the borrower needs to calculate the annual debt service required on each loan, and, in the same way, companies must meet debt service requirements for loans and bonds issued to the public. The ability to service debt is a factor when a company needs to raise additional capital to operate the business.

!--break--Before a company approaches a banker for a commercial loan or considers what rate of interest to offer for a bond issue, the firm needs to compute the debt service coverage ratio. This ratio helps to determine the borrower’s ability to make debt service payments because it compares the company’s net income to the amount of principal and interest the firm must pay. If a lender decides that a business cannot generate consistent earnings to service debt, the lender doesn't make the loan.

How the Debt Service Coverage Ratio Works

The debt service coverage ratio is defined as net operating income divided by total debt service, and net operating income refers to the earnings generated from a company’s normal business operations. Assume, for example, that ABC Manufacturing makes furniture and that the firm sells a warehouse for a gain. The income generated from the warehouse sale is non-operating income because the transaction is unusual. Assume that operating income totaling $10 million is produced from ABC’s furniture sales and those earnings are included in the debt service calculation. If ABC’s principal and interest payments due within a year total $2 million, the debt service coverage ratio is ($10 million income / $2 million debt service), or 5. The ratio indicates that ABC has $8 million in earnings above the required debt service, which means the firm can take on more debt.

Factoring in Leverage

Both lenders and bondholders are interested in a firm’s leverage, and this term refers to the total amount of debt a company uses to finance asset purchases. If a business issues more debt, the company needs to generate higher profits in the income statement to service the debt, and a firm must be able to consistently generate profits to carry a high debt load. ABC, for example, is generating excess earnings and can service more debt, but the company must produce a profit every year to service each year’s debt service.

Examples of Capital Structure

Decisions about debt impact a firm’s capital structure, which is the proportion of total capital raised through debt vs. equity. A company with consistent, reliable earnings can raise more funds using debt, while a business with inconsistent profits must issue equity (common stock) to raise funds. Utility companies, for example, have the ability to generate consistent earnings, and these firms raise the majority of capital using debt, with less money raised through equity.

BREAKING DOWN 'Debt Service'

RELATED TERMS
  1. Funded Debt

    A funded debt is a company's debt that will mature in more than ...
  2. Debt Ratio

    The debt ratio is a financial ratio that measures the extent ...
  3. Debt Financing

    Debt financing occurs when a firm raises money for working capital ...
  4. Net Debt

    A metric that shows a company's overall debt situation by netting ...
  5. Cost of Debt

    The effective rate that a company pays on its current debt. This ...
  6. Debt

    An amount of money borrowed by one party from another, often ...
Related Articles
  1. Small Business

    Total Debt to Total Assets

    Total Debt to total assets, also called the debt ratio, is an accounting measurement that shows how much of a company’s assets are funded by borrowing. In business, borrowing is also called leverage.
  2. Investing

    Understanding Leverage Ratios

    Large amounts of debt can cause businesses to become less competitive and, in some cases, lead to default. To lower their risk, investors use a variety of leverage ratios - including the debt, ...
  3. Investing

    Evaluating a Company's Capital Structure

    Learn to use the composition of debt and equity to evaluate balance sheet strength.
  4. Personal Finance

    Why Debt Isn’t Always a Bad Thing

    When managed properly, debt can be used to achieve a higher overall rate of return.
  5. Insights

    The National Debt Explained

    We know it's growing, but we don't know exactly how. An in-depth look why the U.S. Government's debt continues to balloon and what it all means for you.
  6. Financial Advisor

    The 4 Best Debt Reduction Services

    It can be tricky to find the best debt reduction services for your financial situation. These top 4 debt consolidation firms help make the process easier.
  7. Personal Finance

    Best 5 Money-Saving Tips to Get out of Debt

    Understand the different types of debt and the reasons why people get into debt. Learn about five tips to follow to get out of debt.
  8. Investing

    4 Leverage Ratios Used In Evaluating Energy Firms

    These four leverage ratios can help investors evaluate how energy manage their debt.
  9. Personal Finance

    The Generational Debt Gap

    Are future generations in trouble when it comes to how much debt they have? We compare debt between other age groups to find out.
RELATED FAQS
  1. What is the difference between the debt ratio of a company and the debt ratio of ...

    Discover the different financial evaluation measures that are most commonly applied to individuals and corporations, respectively. Read Answer >>
  2. If a company has a high debt to capital ratio, what else should I look at before ...

    Learn about some of the financial leverage and profitability ratios that investors can analyze to supplement examining the ... Read Answer >>
  3. How do I use the debt ratio to decide when to invest in a company?

    Understand the calculation and interpretation of the debt ratio and how this metric is used by investors to analyze a company's ... Read Answer >>
  4. When should a business avoid debt financing?

    Read about the optimal use of debt in a business capital structure and how to know when a business should avoid further debt ... Read Answer >>
  5. What measures should a company take if its total debt to total assets ratio is too ...

    Learn how the total debt to total assets ratio is analyzed by investors and lenders, and how a high ratio can be remedied ... Read Answer >>
Hot Definitions
  1. Earnings Per Share - EPS

    Earnings per share (EPS) is the portion of a company's profit allocated to each outstanding share of common stock.
  2. Trustee

    A person or firm that holds or administers property or assets for the benefit of a third party. A trustee may be appointed ...
  3. Gross Domestic Product - GDP

    GDP is the monetary value of all the finished goods and services produced within a country's borders in a specific time period, ...
  4. Debt/Equity Ratio

    The D/E ratio indicates how much debt a company is using to finance its assets relative to the value of shareholders’ equity.
  5. Exchange-Traded Fund (ETF)

    A security that tracks an index, a commodity or a basket of assets like an index fund, but trades like a stock on an exchange.
  6. Net Present Value - NPV

    Net Present Value (NPV) is the difference between the present value of cash inflows and the present value of cash outflows ...
Trading Center