Debt Service: An Overview of Calculations and Ratios

What Is Debt Service?

Debt service refers to the money 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.

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 that 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, then 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 nonoperating income because the transaction is unusual.

If ABC’s furniture sales produced annual net operating income totaling $10 million, then that number 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.

The Bottom Line

Debt service refers to the money that a person, business, or government needs 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.