Debt Service: Definition, Overview & How to Calculate
Have you ever used a credit card and forgotten to pay off your balance? Maybe you took out a student loan and want to know how much you need to contribute to help pay it off more efficiently. Whatever type of debt it is, debt service is an effective way to help figure out how much you need to pay and when.
This can be an important strategy to use if you want to take on more debt in the future. And it works similarly for both individuals and businesses. Creditors want to know if you have a solid credit history of servicing debts before they issue another loan, for example.
Read on to learn all about debt service and how it works. We will break down how to calculate it and touch on the debt service coverage ratio.
Table of Contents
- Debt service is the amount of cash that’s needed to pay back interest and principal amounts on any outstanding debt.
- Knowing that a company can cover its debt load, plus any new debt, is important information for lenders to know and understand.
- Generating reliable and consistent profits to service debt is critical for a company to be able to carry a high debt load.
- The debt service ratio is a financial tool to help assess the leverage a company has.
What Is Debt Service?
Debt service refers to the amount of cash that’s needed to repay the principal and interest on a debt. The amount is for a specific period of time. For example, if you take out a student loan or a mortgage, you will need to calculate the monthly or annual debt service that’s required and any additional resources.
It works the same way for a company, as well. In this case, a company would need to meet the debt service requirements for any bonds or loans that were issued. A company’s ability to service debt becomes an important factor when it looks to raise capital for business operations.
Importance of Debt Service
Being able to raise funds and capital is an important part of any business venture. One of the best ways to do this is by borrowing money. However, obtaining debt and carrying it isn’t always as easy as it might seem and it can affect the balance sheet of a company.
Plus, in order to carry debt, the bank, investor, or lending institution needs to trust that the borrower will be able to repay. In essence, the debt servicing capacity of a company is a key indicator of trustworthiness.
When a company can service its debts consistently, it’s going to have a good credit score. In turn, this is going to increase the opportunity of being approved by lenders for future credit for more sustainable debt.
It works the same way for individuals, as well, who will have to manage their personal finances by focusing on debt servicing. When debts are serviced consistently your credit score will increase, which will improve the chance of receiving a car loan, a mortgage, reducing credit card debt, or a wide range of other debts.
How Debt Service Works
Determining the debt service coverage ratio is often one of the first things a company will do before it approaches a financial institution or banker. If it is looking to take out a commercial loan or wants to know what to offer for the rate of interest for a bond issue, this is important to know.
Understanding the debt service coverage ratio will help gain insight into how well the borrower can make any debt service payments. This is because the ratio compares the amount of interest and principal that must be paid against the company’s net operating income.
If the ratio shows that the business isn’t going to be able to have consistent earnings to pay off the device debt, the loan won’t be issued by the lender. However, both bondholders and lenders are going to be interested in the leverage a company has and their debt levels.
Leverage refers to the amount of current debt load a company can use to finance asset purchases. When a business takes on additional debt capacity, it’s going to need to earn higher profits in its income statement to cover the debt obligations.
As well, the business will need to generate these profits consistently to be able to carry the high debt load. Certain debt decisions are going to affect the overall capital structure of a company. So, one with reliable and consistent earnings will be able to raise extra funds using its debt.
On the flip side, a business that has inconsistent profits will usually issue equity to raise funds, such as common stock.
How Do You Calculate Debt Service?
Calculating debt service is fairly simple, all you’re going to need to do is have knowledge of or access to the loan’s repayment schedule and interest rate. Then, you need to calculate the principal payments and the periodic interest that’s due on a loan.
Debt service calculations play a big role in determining how much cash flow would be required to cover payments. This is why calculating the annual debt service is so useful. From here, you can use the calculations to compare against the annual net operating income of a company.
Debt Service Coverage Ratio (DSCR)
Before a business is able to start borrowing, it needs to determine its debt service coverage ratio (DSCR). This ratio is important to measure the ability of the company to make its debt payments on time.
To calculate the DSCR, you divide the net income of a company with the total amount of principal and interest that needs to get paid. When a company has a higher ratio, it’s going to have a better chance to obtain a loan.
The debt servicing capability of an individual or a company refers to its ability to repay the interest and principal on debt obligations. For example, a range of debts such an amortized loan, capital loans, mortgage loans, or personal loan, will require payment on time.
A prospective borrower will have certain requirements for loans that will be outlined in the repayment schedule for eligible debt. Essentially, debt service is how trustworthy a borrower is to pay off the remaining loan. The debt restructuring process can also play a big role in any debt burdens, such as yearly debt
Debt Service FAQs
What Is a Good Debt Service Ratio?
Usually, it’s a good rule of thumb to not have your debt service ratio go above 30% of your income.
What Is an Example of Debt Service?
If you take out a loan for $100,000 for 10 years with 6% interest, debt service will often be calculated based on 12 monthly payments. In this case, each monthly payment would be roughly $1,110, or just over $13,000 annually.
What Is a Debt Service Schedule?
A debt service schedule is the outlined schedule in which the interest and principal amounts are due. It will outline payment dates and the amount that’s going to be paid and is provided by the bondholder.
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