Debt service refers to the cash that is necessary to be paid over a certain period of time in order to repay both principal and interest on a given debt. For individuals, monthly mortgage payments, or credit card bill payments, prove to be good examples of personal debt service. For businesses, payments on lines of credit, business loans, or coupon payments of bonds represent samples of corporate debt service.
Where businesses or personal debt service is concerned, this is used to calculate the DSCR, or debt service coverage ratio. This ratio is that of the cash that is on hand for servicing the debt’s principal, interest, and lease payments. This measurement is a much utilized benchmark that helps to determine a company or an individual’s capability of generating sufficient money to cover the payments on their debt. With a higher debt service coverage ratio, loans are easier to get for both companies and people.
The commercial banking industry also employs this phrase. Here, it can refer to the minimally acceptable ratio that a given lender will accept. This might turn out to be a condition of making the entity such a loan in the end. When this type of a condition is part of the loan covenant, then violating the debt service coverage ratio can sometimes be considered an action of default.
Debt service coverage ratios are similarly used in the world of corporate finance. Here, they describe the sum of available cash flow that is usable for covering yearly principal and interest payments on any and all debts. This includes payments for sinking funds.
Commercial real estate finance similarly utilizes debt service and debt service coverage ratios as the main means of discovering if a given property is capable of maintaining its level of debt using only its own cash flow. In the past ten or so years, banks would look for a minimum debt service coverage ratio of minimally 1.2. Banks that proved to be more aggressive were willing to work with lower ratios.
This practice led to greater risk in the system that helped to bring on the financial meltdown and resulting crisis that stretched from 2007 to 2010. When an entity has more than a ratio of one debt service coverage ratio, it is theoretically capable of covering its debt requirements with cash flow. Similarly, if this ratio is less than one, then the statistics claim that an insufficient amount of cash flow exists to meet the required loan payments.