Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail
Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail

Debt Service

What it is:

Debt service is the act of making interest and principal payments on debt.

How it works (Example):

For example, let's say Company XYZ borrows $10,000,000 and the payments work out to $14,000 per month. Making this $14,000 payment is called servicing the debt.

Borrowing money allows companies to make investments without having to commit a lot of their own capital, but the even greater purpose is to maximize shareholder value. As in personal finance, too much debt can be a very, very bad thing, but a little can go a long way. For most investors, it is thus usually unwise to avoid investing in companies with debt; the trick is to find companies that manage their debt well.

This is why companies must consider how debt service fits into their expansion plans if they're using debt to fund the expansion. For example, if Company XYZ is using its borrowed $10,000,000 to build a factory that won't produce anything for five years, how will it service the debt between now and then? In other words, where will it scrape up the cash for those $14,000 payments until the factory is online? And is it sure that the factory will generate at least $14,000 per month once it is online? This is the risk that companies take with debt.

Why it Matters:

Companies that issue bonds are perhaps the most well-known debt servicers. They must provide their bondholders with set interest and principal payments on specified dates, and in some cases, must be willing to convert that debt into equity at specified ratios or repay the debt early if certain events occur. When a debtor fails to service its debt, the debtor is sometimes considered in default. In some cases, even the speculation that a debtor might not be able to service its debt can cause its stock price to go down and make it very difficult to obtain financing or other help later.

Because debt service responsibilities can vary among similar companies, some financial measures, particularly EBITDA, intrinsically exclude debt structures in their calculations so comparisons can be made more directly.

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