Loan payments required to be paid back to a lender as considering debt service. Often used to calculate the DSCR for commercial real estate financing, and in evaluating investment returns.
Debt service refers to the amount of money that a company or an individual needs to pay off a debt which includes the interest and the principal amount. This amount needs to be paid back in a specific amount of time. This term is applicable for all types of loans including, but not limited to, corporate or government loans and bonds.
For businesses and organizations, debt service is usually calculated per annum. In order to clear this debt amount, a company must have a stable revenue and profits that it will use to pay off the debts and other obligations. For individuals, they must have a steady source of income to pay off the debt.
A debt service can be any form of loan that an individual or business has taken to run their operations. For example, if a person has taken a loan from the bank to purchase a house, the debt service will be the loan amount or the principal amount they have taken plus the interest that they will pay each month on that loan for a specific period. This period is determined by the lender such as banks or other financing institutions.
In the case of a company, the terms remain the same. Examples of debt service are:
To start a business, a company needs a big amount of money to begin operating. This amount cannot always come from the savings of the company owner, so the company requires to take a loan. For any bank or financing institution to lend this money, they will need proof of creditworthiness of the business owner. This creditworthiness can be determined by the debt servicing capacity.
A company that takes a loan and pays it off in time including the interests will have a good credit history and score. This will establish that the company is trustworthy to pay off any amount that they borrow. It means that the company is generating constant revenue and profits that allow the company to pay off their obligations.
For individuals too, creditworthiness is important. Based on their credit score they will be able to get a loan in the future. Hence, debt service is an important factor to monitor by lenders and for individuals to ensure they can borrow funds when needed.
Debt service is calculated by adding the principal amount of the loan and the interest on it for each month. This can also be calculated annually. For businesses and individuals, it is important to gather the information on monthly payments and the repayment schedule.
Let’s understand this calculation with an example. Suppose a company has issued a bond of $2,00,000 and agreed to pay an annual interest of 5% on the loan amount (not the outstanding principal). The term of the loan is 5 years, meaning the company has to pay off the amount of $2,00,000 at the end of 5 years. It also means that the company has to pay $40,000 at the end of each year plus 5% annual interest on the principal amount.
In this case, the annual amount of debt service for each year will be $40,000 + $10,000 (interest) which is equal to $50,000. Hence, the annual debt service of the company is $50,000.
Like this, the debt service can be calculated on agreed terms. In this case, if the company and the lender had agreed on 5% interest on the outstanding principal amount each year, then the interest amount would have reduced as the interest would then be calculated on the remaining principal amount. This means, each year, if the company paid $40,000, then the outstanding principal amount would be reduced by $40,000 and the 5% interest would be calculated on the reduced principal amount.
A debt service coverage ratio determines the company’s available cash flow to pay off any debts. The DSCR is a metric that banks and other financing institutions use to determine the ability of a company to pay off the debts and whether the company is seeing profits or losses. It also helps them to understand the future of the company. In short, the DSCR provides the financial health of a company.
It is calculated by dividing the company’s net operating income by annual debt service.
The formula to calculate DSCR is:
DSCR = Net Operating Income ÷ Annual Debt Service
For example, let’s say a company named AZY Ltd. has an annual net operating income of $5,00,00 and the annual debt service is $4,00,000. We can calculate the DSCR by applying the above formula:
DSCR of AZY Ltd. = 5,00,000 ÷ 4,00,00
DSCR of AZY Ltd. = 1.25
Generally, lenders consider DSCR of above 1.25 as good. This means that the company is generating enough revenue to pay off the debt and have some revenue left for other purposes. A DSCR of 1 means that the company is using all of its net operating income to pay off debts. This may not be a desirable condition to borrow more money in the future.
Much like the DSCR, the DRI ratio is a metric to determine the capability of an individual to pay off the loan and whether they will be in a position to borrow more money in the future. In the DTI ratio, the person’s gross income for a month is divided by their debt obligations.
For example, if a person’s gross income is $10,000 and their debt obligation for a month is $4000, then the DTI would be:
DTI = 10,000 ÷ 4,000 = 2.5
Debt service is an important metric for both lenders and borrowers to determine the long term goals of the company. If the debt obligation is higher than the revenue that the business generates then the business will need to come up with a plan to improve the revenue. When a lender finds out the debt service of a company, it may or may sanction the loan amount based on the creditworthiness of the company. It is important for borrowers to keep a note of their debt service and plan future steps accordingly.