Debt Service

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What Is Debt Service?

Debt service is the cash required to cover the principal and interest payments on a loan or other debt over a specific period (usually a year). It applies to individuals (mortgages, student loans), businesses (commercial loans, bonds), and governments. To “service” debt simply means making the scheduled payments.

Debt-Service Coverage Ratio (DSCR)

Definition and formula
* DSCR measures a borrower’s ability to meet debt obligations from operating income.
* Formula: DSCR = Net Operating Income / Total Debt Service
* Net operating income (NOI) = income from normal business operations (excludes nonoperating gains).
* Total debt service = principal + interest payments due in the period.

Why it matters
* Lenders and bond investors use DSCR to assess leverage and repayment capacity.
* A higher DSCR indicates more cushion to absorb debt payments and take on additional debt.
* A DSCR less than 1 means operating income is insufficient to cover debt service and signals financial stress.

Example
* ABC Manufacturing has NOI of $10 million from furniture sales. Its annual principal + interest payments total $2 million.
* DSCR = $10M / $2M = 5.0 — a strong coverage ratio that indicates capacity to take on more debt.

What Is a Good DSCR?

  • Higher is better. Lenders commonly look for at least 1.25 for commercial loans.
  • DSCR = 1.0 means all operating income goes to debt payments — little margin for error.
  • DSCR < 1.0 suggests the borrower is paying more in debt service than it earns from operations and may be unsustainable.

Debt-to-Income (DTI) Ratio — Personal Equivalent

  • DTI measures an individual’s ability to service debt: DTI = Total monthly debt payments / Gross monthly income.
  • Example: $5,000 monthly income with $2,000 monthly mortgage = 40% DTI.
  • Acceptable DTI thresholds vary by lender and loan type; lower DTI is generally viewed more favorably.

Loan Servicing vs Debt Servicing

  • Loan servicing: administrative tasks performed by lenders or servicers (billing, payment processing, statements).
  • Debt servicing: the borrower’s act of making payments to reduce principal and interest.

How Debt Decisions Affect a Business

  • Leverage and capital structure: Debt vs. equity decisions determine how a company finances assets.
  • Companies with stable, predictable earnings (e.g., utilities) can carry higher debt loads because they reliably generate the cash needed for debt service.
  • Firms with volatile earnings may need to raise funds through equity rather than debt.
  • Overleveraging (too much debt relative to income) increases default risk and limits future borrowing options.

Key Takeaways

  • Debt service = payments of principal + interest over a period.
  • DSCR evaluates whether operating income covers debt service; lenders often seek DSCR ≥ 1.25.
  • DTI is the personal-finance analogue to DSCR and varies by lender.
  • Loan servicing is administrative; debt servicing is the borrower’s payment obligation.
  • Maintaining adequate coverage and consistent earnings is essential to safely carry and raise debt.