What Is a Debt Service Ratio In a Business Loan?
How Debt Service Works in Business Loans
If you have been to a bank recently to apply for a business loan, the banker may have started doing calculations and talking about debt service and debt service ratios. What's up with that?
What is Debt Service?
Debt service is the amount of money required over a period of time to repay debts. It includes repayment of:
- principal and interest
- and lease payments (on business vehicles, for example)
This amount is usually calculated for a year.
Let's say you are looking at al loan of $100,000 to expand into a larger space. At 6% interest for 10 years, the monthly payments are $1110.21, or $13,322.52 a year. That's your debt service for the year.
The banker is going to ask you how your business will be able to generate enough income to make those monthly payments, how you are going to service the debt.
Debt Service as an Important Key to Business Credit
Debt service is one of the 4 C's of Business Credit (capital, collateral, capacity, and character. Debt service represents the capacity to repay the loan. It's the ability of the business to generate revenues to pay off business loans and 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 debtor. Yes, your business credit rating will show this too, but lenders have found debt service to be a reliable indicator of repayment potential.
What is a Debt Service Ratio?
As noted above, the main question any lender wants to know is: "Will this new debt put you (the borrower) into a position of struggling to pay current debts and this new debt?"
It's not enough to know the amount of debt that needs to be paid off over a year's time. It's also essential to know how much income the business can use to pay off these debts.
Here's the calculation for Debt Service Ratio:
Divide the business net operating income for a year by the amount of the total debt to be paid off (serviced) during that year.
Net operating income is used because this is the amount of income that comes from annual sales of products and services, but not from additional sources like investment income.
As an example: A business has two outstanding loans that total (with principal and interest) $100,000, and a business car lease that has annual payments of $8,000. That totals $108,000 in debt service.
Last year, the business had net operating income of $156,000. Divide $156,000 by $108,000 for a debt service ratio of 1.44%.
A ratio of 1 to 1 is minimal. It means that all of the business's net income for a year will need to be used to pay off existing debt. A ratio of .8 to 1 means that only 80% of the existing debt can be paid from the business's net income.
How Does Debt Service Work for a New Business?
Since a new business doesn't have a track record of net income, it has a bigger difficulty persuading a lender that it has the ability to pay off its debt. New businesses probably won't get traditional loans and will have to seek creative financing methods until they can show net income to offset debt service.
Debt Service As a Reality Check on Expenses
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. Putting debt service as an expense shows how it adds in with other expenses as compared to the income your business will be getting each month.
While debt service may be a large part of your business' expenses, it's not the only one. In the example above, net operating income has to cover ALL of your business expenses, not just the monthly payments on your debt. Look at this statement including debt service to do a reality check even before you take your loan request to a bank.