Debt service refers to the funds necessary to cover the interest and principal on a loan or other debt for a specified period of time. Individual debts, such as a mortgage or student loan, as well as corporate or government debts, such as business loans and debt-based securities, such as bonds, are included. When an individual applies for a loan or a business needs additional capital to operate, the ability to service debt is a crucial consideration. To "service a debt" is to make the required payments on that debt.
What Is Debt Service?

• Debt service refers to the funds necessary to pay the principal and interest on a delinquent debt for a specified time period.

• The debt service ratio is used to measure the leverage of a company.

•Prospective lenders or bond purchasers want to know that a company will be able to service additional debt in addition to its existing debt.

A business must generate consistent and dependable profits to service its debts in order to carry a high debt load.

How Debt Service Works

Before approaching a bank or other lender for a commercial loan or deciding what interest rate to offer on a new bond issue, a company must evaluate its debt-service coverage ratio (DSCR). This ratio compares the net operating income of a company to the amount of principal and interest it must pay on its current debts. If a lender determines that a company cannot generate consistent earnings to service the new debt in addition to its existing debts, the lender will not grant the loan.

Lenders and bond investors are interested in the leverage of a company. This refers to the total amount of debt used to finance the acquisition of assets. If a business intends to incur more debt, it must generate greater profits to service the debt, and it must be able to generate profits consistently to carry a high debt load. A company with excess earnings may be able to service additional debt, but it must continue to generate sufficient profits each year to cover debt service. Over leveraged refers to a company that has taken on too much debt relative to its income.

The proportion of a company's total capital raised through debt versus equity is influenced by debt-related decisions. A company with consistent, reliable earnings can raise additional capital through debt, whereas a company with inconsistent profits must issue equity, such as common stock, in order to raise capital. For instance, utility companies are able to generate consistent profits because they frequently lack competitors. These companies raise the majority of their capital through debt and a smaller amount through equity.

Example of calculating the Debt-Service Coverage Ratio

As previously stated, the debt-service coverage ratio is calculated by dividing net operating income by total debt service. Net operating income consists solely of profits derived from a company's regular business operations.

Suppose, for instance, that furniture manufacturer XYZ Manufacturing sells one of its warehouses for a profit. The profit from the warehouse sale is non-operating income due to the unusual nature of the transaction.

If XYZ's furniture sales generated an annual net operating income of $12million, that amount would be used to calculate debt service. Therefore, if XYZ's annual principal and interest payments total $3 million, its debt-service coverage ratio would be 4 ($12 million in income divided by $3 million in debt service). Due to this relatively high ratio, XYZ is well-positioned to incur additional debt if it so chooses.

What Does a Good Debt-Service Coverage Ratio Look Like?

In general, the greater the height, the better. However, business lenders will typically require a ratio of at least 1.25.

A debt-service ratio of 1 indicates, for instance, that a company is devoting all of its available income to debt repayment, a precarious situation that would likely make additional borrowing impossible.

Additionally, businesses can have a debt-service coverage ratio of less than 1, indicating that it costs them more to service their debt than they generate in revenue. However, a business in such a situation may not last long.

What is a Debt-to-Income Ratio?

A debt-to-income (DTI) ratio is similar to a debt-service coverage ratio, though it is typically applied to non-business (personal) borrowing. The DTI ratio measures a person's ability to service debt by dividing their gross income by their debt obligations for the same period. A person with a monthly income of $4,000 and a mortgage payment of $1,000 would have a DTI of 25%. The acceptable DTI varies from lender to lender and loan product to loan product.

Are Loan Servicing and Debt Servicing the Same?

Although they sound alike, loan servicing and debt servicing are distinct concepts. Administrative tasks such as sending monthly statements to borrowers and processing their payments are examples of loan servicing. Debt servicing refers to the repayment of a loan or other debt by a borrower.

The Bottom Line

Debt service refers to the funds a person, business, or government needs to make loan or other debt payments over a specified time period. A company's debt-service coverage ratio compares its available income to the amount it is currently paying to service its debts. This ratio indicates the company's ability to service additional debt.