Introduction

Debt service refers to the total amount a borrower is obligated to pay over time to repay both the principal and interest on a loan. It is a fundamental concept in finance, applicable to corporations, governments, and individual borrowers. Proper debt servicing ensures financial health and creditworthiness, while the inability to service debt may lead to default, credit downgrades, or financial distress.

For companies, debt service is a key factor that determines their ability to raise additional funds, as lenders and investors assess whether the borrower can manage existing debt obligations before extending further credit.

This article explores the meaning of debt service, its components, its importance in corporate finance, and how it is evaluated in the Indian financial ecosystem.

What Is Debt Service?

Debt service is the sum of all principal repayments and interest payments that a borrower needs to make over the life of a loan or bond. It applies to all types of debt, including term loans, corporate bonds, government borrowings, and mortgages.

In simpler terms, servicing the debt means making regular repayments as per the loan agreement, whether monthly, quarterly, or annually.

For example, if a company takes a ₹10 crore loan at an interest rate of 9% per annum, it must repay the interest periodically and eventually repay the principal, forming part of its total debt service obligation.

Components of Debt Service

1. Principal Repayment

• The original amount borrowed that needs to be repaid over the loan tenure.
• Can be repaid in full at maturity or in installments over time.

2. Interest Payments

• The cost of borrowing, calculated as a percentage of the outstanding loan balance.
• Paid regularly, often monthly, quarterly, or annually.
• For instance, a company that borrows ₹5 crore at 10% interest for 5 years will pay ₹50 lakh annually in interest, along with scheduled principal repayments.

Importance of Debt Service in Finance

1. Creditworthiness Assessment

• Lenders and investors use debt service data to evaluate whether an entity can meet its repayment obligations without stress.
• A company with strong debt service capability is considered low-risk.

2. Capital Raising Decisions

• When businesses seek additional capital (through loans or bonds), financial institutions first review their existing debt servicing capacity.
• A company already struggling with debt service is unlikely to secure new funding.

3. Business Continuity and Stability

• Proper debt service ensures operational continuity, as missed payments can lead to penalties, lawsuits, or bankruptcy.

4. Affects Credit Ratings

• Credit rating agencies like CRISIL, ICRA, and CARE assess a borrower’s ability to service debt.
• Poor debt servicing history can result in credit downgrades, making future borrowing costlier.
• For example, a listed company with a history of delayed interest payments may see its bond yields rise and stock prices fall, impacting investor confidence.

Debt Service Coverage Ratio (DSCR)

One of the most important financial indicators used to evaluate debt service capability is the Debt Service Coverage Ratio (DSCR). It measures a company’s ability to use its operating income to repay debt obligations.

• DSCR = Net Operating Income / Total Debt Service
• A DSCR above 1 means the entity generates sufficient income to cover its debt payments.
• A DSCR below 1 indicates potential difficulty in meeting obligations.
• For example, if a company has ₹2 crore in net operating income and ₹1.5 crore in total debt service, its DSCR is 1.33, which is considered healthy.

Challenges in Debt Servicing

1. Economic Downturns

• During recessions or market slowdowns, companies may experience cash flow issues, affecting their ability to service debt.

2. Rising Interest Rates

• If loans are based on floating interest rates, an increase in rates can inflate interest payments, straining finances.

3. Overleveraging

• Companies with excessive debt face difficulty managing interest and principal payments.

4. Currency Fluctuations

• For entities with foreign currency borrowings, currency depreciation can increase repayment costs in domestic terms.
• For instance, several Indian infrastructure companies faced debt servicing issues during the 2012–2014 slowdown, as revenue projections fell short.

Debt Service in India

In India, debt service is a critical metric monitored by:

• RBI while regulating bank lending and monitoring systemic risk.
• Banks and NBFCs while approving loans or restructuring debt.
• SEBI and credit rating agencies for listed entities and bond issuers.
• Investors in corporate bonds, who use debt servicing data to assess risk and return.
• For example, under RBI’s Prudential Framework, banks are required to classify accounts with poor debt service records as non-performing assets (NPAs).

How Companies Improve Their Debt Servicing Ability

• Improve revenue and cash flows to increase net income.
• Restructure existing loans to extend tenures or reduce interest rates.
• Issue equity instead of debt to avoid increasing repayment obligations.
• Prioritize high-cost debt repayment to reduce interest burden.
• A good example is when companies like Tata Steel and Reliance Industries sold non-core assets and reduced debt to strengthen their balance sheets and improve servicing capacity.

Conclusion

Debt service is a core element of financial management, representing the total principal and interest repayments a borrower is obligated to make over time. It reflects a company’s or borrower’s financial strength, creditworthiness, and operational sustainability.

Reference used: https://www.investopedia.com/terms/d/dscr.asp

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