Managing debt or implementing debt service is one of the most important responsibilities of small business owners and finance managers. Both individuals and organizations need loans at times for purchasing expensive assets and other reasons. In the case of individuals, the borrower has to calculate the monthly or yearly debt service required for the loans.
Similarly, companies or businesses need debt services for issuing loans and bonds to the public. When a business needs higher capital, it looks for debt service. In this article, details of debt service will be discussed. You will know about the debt service formula, coverage ratio, and other details. So, what is debt service? Find the answer below.
Importance of Debt Servicing
For every business, funding is an important thing. Many businesses acquire the fund by borrowing money from lenders. Many enterprises apply for bank loans, while some enterprises look for other lenders. Banks, financing companies, investors, lending institutions, and other lenders should trust the borrower.
Borrowers must ensure that they will pay back the loan without causing inconveniences for the lenders. However, verbal assurance does not work in lending and borrowing a high amount of money. Lenders check the credit history and credit score of the borrower. Moreover, they also check the debt servicing capacity of the borrower.
It can fetch a good credit score for a business. A boost in credit score makes a borrower more trustworthy to the lenders. Thus, every startup and enterprise should understand what is it.
Besides, they should know how debt servicing works. If a company maintains debt servicing capability, it will get loans easily. Not only businesses or enterprises, but individuals can also focus on debt servicing for dealing with their finances.
How Can You Calculate Debt Service?
One should also understand the process of calculating debt service. The typical method of calculating debt service is calculating principal payments along with the periodic interests.
For calculating these parameters, one needs to know the rate of interest on repayment of the loan. Furthermore, you should also know the period for repaying the loan. Through the debt service calculation, one can assess the cash flow required for a hassle-free repayment process.
Most businesses schedule their debt service calculation in certain time intervals. Depending on the requirement of the loans, businesses schedule their debt service calculation process.
While some businesses schedule calculations annually, a few businesses schedule more frequent debt service calculations as they need loans frequently. When debt service gets calculated, it has been compared with the net operating income of a company in a year. The comparison helps the lenders to assess a borrower’s financial competence for settling a debt.
Debt Service Coverage Ratio (DSCR)
Debt Service Coverage Ratio (DSCR) is an important thing for every business. Before borrowing an amount from the lender, businesses need to calculate DSCR. Knowing what debt service is will be incomplete without knowing the process to calculate DSCR. Would the borrower pay the debt in time? Every lender has this question in mind.
DSCR fetches the answer to this question. It indicates the financial stability and capability of a borrower to repay the loan within the stipulated time.
Debt Service Coverage Ratio helps to build trust among the lenders. A borrower will get a loan easily if DSCR indicates that the borrower can return the principal amount with interest on time. To know what debt service is, you should also know the formula to calculate DSCR. Here is the debt service formula for you at a glance.
DSCR = Annual Net Operating Income / Annual Debt Payments
What Indicates a Good DSCR?
So, how do the lenders judge the capability of loan repayment of the borrower through DSCR? What should be the ideal value debt service coverage ratio? The answer to this question is tricky. In simple words, the debt service coverage ratio does not have a maximum or minimum value.
When the ratio is high, it indicates a good thing. Similarly, the low value of the ratio indicates financial instability and incapability of repaying the debt. When the net income and debt of a company are equal, DSCR value will be one.
When the DSCR value is above one, it indicates that the net operating income of a company is higher than the debt obligations. Similarly, a DSCR value below one tells that the company has more debt than its net operating income. As a result, the company is incapable of handling new debts.
Who Calculates the DSCR?
Calculating DSCR is standard practice for a lender before offering a loan to a business. What is the debt service coverage ratio? Every lender seeks the answer before approving a loan request. Apart from the lenders, the companies also check their DSCR periodically. After completing the repayment of a loan, a borrower has to check the DSCR. Checking DSCR helps the companies in the following ways.
- DSCR helps the companies to decide on making loan requests. If DSCR is near to one, the company may not get a loan easily.
- Checking DSCR helps the company to track the difference between net income and loans. As a result, companies can take future financial plans depending on DSCR.
How to Improve DSCR?
What is the debt service coverage ratio? How can a business improve the ratio? Through various financial strategies, a company can improve the debt service coverage ratio. For example, a business can try the following tried and tested strategies.
- Do not take unnecessary loans. A business should borrow money only when it is essential. Lesser loans will keep DSCR high.
- Increasing productivity is the key to widen the gap between net income and total debt. The increasing gap between the two will give you a higher DSCR.
- Timely loan repayment is essential for settling the debt quickly. Not following the repayment schedule increases the burden of debt. As a result, DSCR will keep decreasing.
Every business should conduct a calculation for debt service once a year. It helps the business managers find the company’s financial condition to ask for more loans from the lenders. Knowing “what is debt service” helps businesses to manage their loans easily. On the other hand, lenders calculate debt service for repayment security.