What Is Debt Service?
Debt service refers to the money that is required to cover the payment of interest and principal on a loan or other debt for a particular time period. The term can apply both to individual debts, such as a home mortgage or student loan, and corporate or government debt, such as business loans and debt-based securities, such as bonds. The ability to service debt is a key factor when a person applies for a loan or a company needs to raise additional capital to operate its business. To "service a debt" means to make the necessary payments on it.
- Debt service refers to the money required to pay the principal and interest on an outstanding debt for a particular period of time.
- The debt service ratio is a tool used to measure a company's leverage.
- Prospective lenders or bond buyers want to know that a company will be able to cover any new debt on top of its current debt load.
- In order to carry a high debt load, a company must generate consistent and reliable profits to service its debts.
How Debt Service Works in Business
Before a company approaches a bank or other lender for a commercial loan or decides what rate of interest to offer on a new bond issue, it will need to consider its debt-service coverage ratio (DSCR). This ratio compares the company's net operating income with the amount of principal and interest it is obligated to pay on its current debts. If a lender decides that a business cannot generate consistent earnings to service the new debt along with its existing debts, the lender won't make the loan.
Both lenders and bond investors are interested in a firm's leverage. That refers to the total amount of debt a company uses to finance asset purchases. If a business intends to take on more debt, it needs to generate higher profits to service the debt, and it must be able to consistently generate profits to carry a high debt load. A company that is generating excess earnings may be able to service additional debt, but it must continue to produce a profit every year sufficient to cover the year's debt service. A company that has taken on too much debt relative to its income is said to be overleveraged.
Decisions about debt affect a company's capital structure, which is the proportion of total capital raised through debt vs. equity (i.e. selling shares). A company with consistent, reliable earnings can raise more funds using debt, while a business with inconsistent profits must issue equity, such as common stock, to raise funds. For example, utility companies have the ability to generate consistent earnings, in part because they often have no competitors. These companies raise the majority of their capital using debt, with less of it raised through equity.
Example of a Debt-Service Coverage Ratio Calculation
As mentioned, the debt-service coverage ratio is defined as net operating income divided by total debt service. Net operating income refers only to the earnings generated from a company's normal business operations.
Suppose, for example, that ABC Manufacturing makes furniture and that it sells one of its warehouses for a gain. The profit it receives from the warehouse sale is non-operating income because the transaction is unusual.
If ABC's furniture sales produced annual net operating income totaling $10 million, that is the number that would be used in the debt service calculation. So if ABC’s principal and interest payments for the year total $2 million, its debt-service coverage ratio would be 5 ($10 million in income divided by $2 million in debt service). Because of that relatively high ratio, ABC is in a good position to take on more debt if it wishes to do so.
What Is a Good Debt-Service Coverage Ratio?
Generally speaking, the higher the better. But business lenders will usually want to see a ratio of at least 1.25.
A debt-service ratio of 1, for example, means that a company is devoting all of its available income to paying off debt—a precarious position that would likely make further borrowing impossible.
Companies can also have a debt-service coverage ratio of less than 1, meaning that it costs them more to service their debt than they are generating in income. However, a business in that situation might not survive for long.
What Is a Debt-to-Income Ratio?
A debt-to-income (DTI) ratio is similar to a debt-service coverage ratio, although typically used in personal (non-business) borrowing. The DTI ratio measures an individual's ability to service their debts by dividing their gross income by their debt obligations for the same time period. For example, someone who earns $5,000 a month and pays $2,000 a month on their mortgage will have a DTI of 40%. An acceptable DTI will vary from lender to lender and according to the type of loan product.
Is Loan Servicing the Same as Debt Servicing?
While they sound similar, loan servicing and debt servicing are two different things. Loan servicing refers to administrative work performed by lenders or by other companies they hire, such as sending out monthly statements to borrowers and processing their payments. Debt servicing refers to the process of a borrower paying down a loan or other debt.
The Bottom Line
Debt service refers to the money that a person, business, or government needs in order to cover the payments on a loan or other debt for a particular time period. A company's debt-service coverage ratio measures its ability to handle additional debt by comparing its available income to the amount it is currently paying to service its debts.