What Is Debt Service?
Debt service refers to the debt obligation incurred by a company, individual, or entity. It is calculated annually and comprises the total loan amount, the principal, and the interests. When a firm’s debt burden exceeds operating income, it faces financial crises.
The total debt burden could arise from one or multiple loans. For example, business takes loans for undertaking business operations and new projects. A firm’s ability to repay its debt is measured using the debt service coverage ratio (DSCR). Lenders compute a firm’s DSCR and sanction loans only if the ratio is above 1.
Table of contents
- Debt service refers to total debt obligations accumulated by a business. It is expressed as a ratio and measures firms’ ability to repay debts.
- Usually, firms calculate debt service per annum. It is the ratio of net operating income and debt service.
- A company or an individual with a considerable debt burden and no strong cash flow to justify it will face financial instability in the future. Lenders avoid such borrowers.
- A DSCR of 1.25 is considered the benchmark for businesses.
Debt Service Explained
Debt service refers to a company’s total debt. It is the amount a company is expected to pay lenders or bondholders. In most cases, this amount is calculated for a year. In addition to firms, it can also be calculated for individual borrowers; liabilities include auto loans, education loans, and mortgages.
A business must have a steady income and a healthy cash flow for future debts to qualify. Not to mention regular repayments. Thus, if a company’s debt burden exceeds net operating income, it indicates a financial crisis.
Similarly, credit card companies require individual cardholders to pay a percentage of the principal amount and interest to remain solvent. This minimum limit is called credit card debt servicing.
This metric has multiple purposes; for starters,t determines the account to be paid to creditors regularly. Besides, a debt servicing review sheds light on a company’s liquidity and means to fulfill debt servicing obligations (both short-term and long-term). This brings us to the cost Service Coverage Ratio (DSCR).
conceptDSCR calculates companies’ ability to manage current debt obligations—using available resources. This tool is usassociatedith other financial metrics like the debt-to-equity ratio and the debt-to-total assets ratio.
The total debt service ratio is another important indicator—it includes all housing and non-housing obligations of a borrower. This helps lenders derive DSCR for real estate and other loans. Using this, lenders determine borrowers’ ability to repay on time. If the DSCR value is higher than 1, it is considered good; if it is below, one company’s financial health is considered poor. A DSCR of 1.25 is the benchmark for businesses.
It is obvious; a country, company, or individual with a considerable debt burden and no strong cash flow to justify it will face financial instability in the future. Therefore investors, lenders, banks, and financial institutions avoid such borrowers.
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Debt Service Reserve Account
It is also called a DSR; it is like an added security measure for lenders—to avoid borrowers getting overwhelmed by debt burden. DSR assures that the borrower has enough resources to cover future financial obligations.
The reserve account is equal to the projected debt burden for six to 12 months. It acts as a cash buffer when the firm experiences a cash crunch. It benefits borrowers by buying them more time to repay. Well-planned reserves can help businesses survive low-profit phases. In addition, the debtor can use this fund to restructure the loan—this should only be done as a last resort.
Debt Service Fund
A debt service fund is an account that holds cash reserves for payment of interest and principal amounts (on certain types of debts). Many companies set apart readily available cash for the sole purpose of loan repayment. It is a precaution against turbulent times and foreseeable financial crises.
Such companies reduce the risk for investors and lenders as well. This fund has its advantages and disadvantages. Sure, it helps minimize the effective interest rate and makes businesses more reliable. But there is another aspect to it. Sometimes, enterprises play it too safely. Having a substantial debt fund leads to an increased loss in the form of opportunity costs. This strategy (fund) is taking a portion of cash out of circulation. As a result, a chunk of financial resources become unavailable for business operations.
Let us look at some examples to understand debt service calculation better.
Lauren owns a battery manufacturing company. She borrowed $90000 for business expansion—to ramp up production. She acquired the bank loan at a 9% interest rate. The loan tenure was one year.
To calculate debt service, one year is considered. Thus, Lauren is liable to pay $7871 every month. And she spends a sum of $4448 in interest. Therefore, all in all, Lauren repays $94448.
Therefore, Lauren’s annual debt service from this loan is $94448.
Now, most banks and financial institutions check for DSCR.
DSCR = Net Operating Income / Debt Service
- Here, Net Operating Income = Total Revenue – All Operating Expenses
- Total Debt Service = Interest + Principal Repayments + Lease Payments
If Lauren’s operating income is $99999, that is computed as follows.
- DSCR = 99999/94448
- DSCR = 1.05
Again, any ratio above the value of 1 is considered good.
Let’s assume a scenario where Lauren’s operating income was $72000. In that case, the Debt service calculation would be:
- DSCR = $72000/94448
- DSCR = 0.76
It is below 1. This would imply Lauren’s company is facing financial difficulties and is incapable of covering its debt.
Frequently Asked Questions (FAQs)
Lenders and other creditors check the DSCR of a firm before sanctioning loans (especially for small businesses). Ideally, 1.25 is considered the DSCR benchmark—it implies that the firm Escalera 100% of its debts. But realistically, any ratio above 1 is enough to satisfy lenders.
It refers to the principal amount and loan paid by a company over 12 months—without considering insurance, tax, or other expenses.
A higher debt service ratio translates into a business’s ability to cover its debts. Therefore, if this ratio is high, the firm’s financial capability is also high.
This article has been a guide to What debt service is. Here, we explain the debt service reserve account, fund, and its examples. You can learn more about it from the following articles –