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 calculationas 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 