Debt service or debt servicing implies the regular payment of installments of loans. An installment includes interest on debt and a part of the principle. For servicing debt, a company or an individual should have those timely cash flows. If a company is unable to honor its debt service obligations in the absence of required funds, the company is said to be unable to service its debt.
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What is debt service? / Definition
The literal meaning of debt service is ‘paying dues of a debt in the form of interest and principal’. Servicing a debt means paying the interest and the principal on time. Individuals may service debts relating to the home loan, student loans etc whereas companies may have various types of loans like bonds, term loans, working capital loan etc.
Debt Service Calculation with Example
Suppose a company has taken a loan of $100,000 at an interest rate of 10% for a term of 10 years. Considering terms of payment to be 1 installment a year, the first year debt servicing amount would be $16275 consisting of $10,000 of interest payment and $6275 of principal repayment. If quarterly payment opts, the amount would have been $ 3984 (Interest $2500 + Principal $1484).
Debt Service Reserves
Debt service reserves are the reserve funds maintained by a company to ensure full and timely payment of debt service amount. The reserve may be accumulated in the reserve fund out of the debt acquired or revenues over a period of time. Terms and conditions of some debts or bonds may compulsorily require the company to maintain such reserve. It is also another way of ensuring timely serving of debt service obligations by the borrower.
Importance of Debt Servicing
A business cannot run without funds and that is well-understood fact. Hence, debts are an integral part of any business but arranging debt is not an easy task. The bank or institution or any investor for that matter should have the faith in the company before extending debt or investing its hard earned money. Debt servicing capacity is that indicator which assures the investor about the safety of its money. A very well known ratio called ‘debt service coverage ratio’ is calculated to assess the borrower about its capacity to service the debt.
Regular servicing of debt indicates a good credit record for any company. This credit record creates a reputation in the market of investors. Therefore, for the smooth functioning of a business and keep the availability of funds when required, a finance manager should focus on debt servicing on a regular basis.