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 or monthly 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.
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 with 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.
The debt service coverage ratio is defined as net operating income divided by total debt service, where 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.
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.
Decisions about debt affect 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.