What Is Debt Service?
Let me explain debt service directly: it's the money you need to cover the interest and principal payments on a loan or any other debt over a specific period. This applies to your personal debts like a home mortgage or student loan, as well as to corporate or government debts such as business loans or bonds. When we talk about servicing a debt, we're referring to making those necessary payments on it.
Key Takeaways
Debt service is the money required for principal and interest on outstanding debt in a given time frame. The debt service ratio helps measure a company's leverage. Lenders and bond buyers check if a company can handle new debt alongside existing obligations. To manage high debt, a company needs consistent profits to service it.
How Debt Service Works in Business
Before approaching a lender for a loan or setting an interest rate on a new bond, you should look at your debt-service coverage ratio (DSCR). This ratio compares your net operating income to the principal and interest you're obligated to pay on current debts. If a lender sees inconsistent earnings, they won't approve the loan because you won't be able to service the new debt on top of what's already there.
Lenders and investors focus on your leverage, which is the debt you use to finance assets. Taking on more debt means you need higher profits to service it, and you must generate those profits consistently to handle a high debt load. If your debt exceeds your income capacity, you're overleveraged.
Debt decisions impact your capital structure—the mix of debt versus equity like selling shares. With reliable earnings, you can raise more through debt; with inconsistent ones, you'll need equity. Utility companies, for instance, often use mostly debt due to their steady income and lack of competition.
Example of a Debt-Service Coverage Ratio Calculation
The DSCR is net operating income divided by total debt service. Net operating income comes only from normal business operations. Say ABC Manufacturing sells furniture and gains from selling a warehouse—that's nonoperating income, so we exclude it.
If ABC's furniture sales give $10 million in annual net operating income and principal plus interest payments are $2 million, the DSCR is 5 ($10 million / $2 million). That high ratio means ABC can likely take on more debt if needed.
What Is a Good Debt-Service Coverage Ratio?
Higher is better, but lenders typically want at least 1.25. A ratio of 1 means all income goes to debt, leaving no room for more borrowing. Below 1, you're spending more on debt than you earn, which isn't sustainable.
What Is a Debt-to-Income (DTI) Ratio?
Similar to DSCR but for personal borrowing, DTI divides your gross income by debt obligations. For example, $5,000 monthly income with $2,000 mortgage payments gives a 40% DTI. Acceptable levels vary by lender and loan type.
Is Loan Servicing the Same as Debt Servicing?
No, they're different. Loan servicing is the administrative side, like sending statements and processing payments by lenders or their hires. Debt servicing is you, the borrower, actually paying down the debt.
The Bottom Line
Debt service is what you need to pay on loans or debts over a period. Your DSCR shows if you can handle more by comparing income to current payments. Use this to assess your financial position directly.
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