Debt Service
Definition of "Debt service"
When we’re talking about debt service, we refer to the amount of cash required to cover the debt’s repayment of both the interest and the principal for a certain period of time. When an individual takes out a loan, whether it’s a student loan, a mortgage, or a personal loan, the lender will calculate either the annual or monthly debt service compulsory on each loan. As the one that owes debt can be an individual or a company, from companies, lenders may demand a debt service reserve account that acts like a safety measure ensuring that the company will meet their future payment obligations.
Why is Debt Service Important?
Whether it’s an individual or a business, funding is necessary most of the time for either personal financial needs or for business ventures. While borrowing is the most common form of acquiring money, the lender calculates the borrower’s trustworthiness through debt servicing. Like this, the lending institution can tell whether the borrower’s finances are stable enough to be able to repay the loan or not before extending one.
A company or individual that pays their debts on time will have good credit scores. In turn, this will increase their chances for future loans from lenders. When it comes to companies, a finance manager ensures that the company respects its debt service abilities and meets its repayment obligations. Individuals should also focus on their debt servicing. Managing their finances is a good way to ensure that they will be able to meet their repayment obligations and build up their credit score.
What is the Debt Service Coverage Ratio?
We already mentioned that debt service could be calculated monthly or annually. This is done by calculating the interest due and the principal amount. The debt service gives the borrower the amount of payment due for the period calculated, letting them know how much money they need to cover their debt. The reason why debt service is important is that it allows the borrower to always be aware of their financial obligations towards the lender.
In order to make sure that the borrower has enough cash flow to cover their debt and have a profit, the Debt Service Coverage Ratio was designed. This ratio is only applied to businesses, and it is required for any business that wants to borrow money. Lenders require this ratio to make sure the company can make debt payments on time as it is based on the company’s cash flow. This ratio divides the business’s net operating income with the interest and principal it must pay. If the DSCR is higher than 1.0, then the company’s net income is more than the required debt payments. The higher the ratio, the easier it will be for the company to obtain a loan.
The formula for DSCR:
DSCR = Annual Net Operating Income / Annual Debt Service
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