The debt service ratio is one way of calculating a business's ability to repay its debt. It compares income to debt-related obligations. Bankers often calculate this ratio as part of their considerations of whether or not to approve a business loan.
Learn how to calculate this ratio and why it matters.
What Is the Debt Service Ratio?
The debt service ratio—otherwise known as the debt service coverage ratio—compares an entity's operating income to its debt liabilities. Expressing this relationship as a ratio allows analysts to quickly gauge a company's ability to repay its debts, including any bonds, loans, or lines of credit. This is an especially important calculation for bankers, who may be deciding whether or not to allow a business to take on more debt.
The name of the ratio stems from debt service, which is the amount of money required over a period of time to repay debts. A common timeframe for debt service is a year.
If you have a $100,000 loan at 6% interest for 10 years, for example, debt service might be measured by 12 monthly payments of $1,110.21. In other words, your annual debt service for this loan is $13,322.52.
How Do You Calculate the Debt Service Ratio?
To calculate the debt service ratio, divide a company's net operating income by its debt service. This is commonly done on an annual basis, so it compares annual net operating income to annual debt service, but it can be done for any timeframe.
How Does the Debt Service Ratio Work?
To better understand the debt service ratio, consider this example. A business has two short-term loans that total (with principal and interest) $100,000. The business also has a lease on a company car with annual payments of $8,000. Therefore, this company has a total of $108,000 in annual debt service.
Last year, the business had a net operating income of $156,000. Divide $156,000 by $108,000, and you'll get a debt service ratio of 1.44.
You can calculate a company's net operating income—also known as earnings before interest and taxes (EBIT)—by subtracting both direct and indirect costs from total revenue.
A result of one is the lowest ratio a company can have before it starts operating at a loss. This 1:1 ratio means that all of the business's net income for a year will need to be used to pay off existing debt. If the formula's result dips to 0.8, for example, then that means a company can direct all of its net income to debt payments, and it would only cover 80% of its obligations.
An Important Key to Business Credit
Debt service is one of the four C's of business credit (capital, collateral, capacity, and character)—the "capacity" to repay the loan. Debt service measurements verify that a business can generate revenues to pay off business loans, leases, and other debts.
A lender will only lend money to your business if they have a reasonable expectation that the loan will be repaid. One of the major factors in repayment is the current debt being carried by the borrower. Your business credit rating will show this too, but many lenders have found debt service to be a reliable indicator of repayment potential.
Banks and other lenders prefer that you list debt service separately on your income statement (P&L). Debt service is considered a current expense for your business. Listing debt service as an expense shows how it adds in with other expenses and compared to the income your business will be getting each month.
For income tax purposes, the interest on business loans (and payments for some capital leases) is considered a deductible business expense. The loan principal is not a deductible business expense.
Limitations of the Debt Service Ratio
One limitation to the debt service ratio is that it doesn't work well for new businesses. A new business won't have a track record of net income, so any debt service ratio calculation will show an inability to repay debt. Therefore, these businesses may struggle to secure a business loan, and they may have to seek creative financing methods until they can demonstrate enough net income to offset debt service.
While debt service may be a large part of a business's expenses, it's not the only one. Net operating income accounts for these expenses, so it doesn't affect the accuracy of the debt service ratio. However, the debt service ratio won't tell you many details about a business's expenses. For analysts who want to dig into expenses, they'll need to use other calculations and measurements.
- The debt service ratio compares a business's net operating income to its debt-related obligations.
- A result of more than one demonstrates an ability to pay off debt and still profit, and a result below one demonstrates an inability to pay off debt.
- This calculation is most often used during the loan application process—lenders want to ensure that borrowers will be able to honor their debt payments.