How Maximum Annual Debt Service Works

The maximum annual debt service is required by borrowing firms from their lenders to gauge their debt capacity. It is used to determine interest and principles on outstanding long-term loans and bond interest and maturing bonds principal. The calculation is made monthly and multiplied by 12 or done over a fiscal year. A fiscal year is a business or company's working year used to calculate and create budgets and other financial plans.

The calculation for the maximum annual debt service ratio is simple to make. In corporate finance, the present bond debt is paid using the Debt Service Coverage Ratio (DSCR). The DSCR is a determining factor to identify the financial capacity to pay the outstanding interest and principal. Begin by dividing the Net Operating Income (NOI) by the overall annual debt or DSCR.

The company has an excellent operating income when its debt service coverage ratio is 1. Here it shows that the company will cover the annual debt and interest payment mandated by the creditors, but once the ratio gets to two and over, the debt capacity increases; here, it shows that you can handle more debts. An acceptable debt service ratio falls between 1 to 3% depending on the company size and industry. Generally, lenders will not offer a debt that will amount to more than 60% of a company's gross monthly income.

Example of Maximum Annual Debt Service

Company ABC has a Net Operating Income of \$1,350,000 for the year 2020. The lender of a potential loan has indicated that the loan amount would be \$700,000. This \$700,000 will be the overall annual debt.

The maximum annual debt service = \$1,350,000 / \$700,000

The maximum annual debt service = 1.92

The 1.92 indicates that Company ABC can afford to pay back any debt, including the interest that will incur. Satisfied with the maximum annual debt service ratio, the lender completes the loan with Company ABC.

Significance of Maximum Annual Debt Service

There are four reasons a business venture may require a calculation on their maximum annual debt service.

1. Many financial and lending institutions require a maximum annual debt service to determine a firm's borrowing and repayment capacity to acquire a loan. In some cases, lending firms will require the value to be kept in debt service reserve funds.
2. To keep track of an existing debt and repayment set, companies use the maximum annual debt services to identify their debt level and repayment expectation.
3. The maximum annual debt service will determine how much should be set aside in liquid assets to repay loans to set up a debt service fund. It also comes in useful in case of a poor-performing year.
4. To increase your loan capacity and credit score, you are required to maintain a good annual debt service ratio. A company can only achieve a good credit score by keeping records and making payments on time using their maximum annual debt service.

Maximum Annual Debt Service vs. Ratio vs. Requirement

In business finance, three terms will most likely be reoccurring when loans and debts arise; debt service, debt service ratio, and debt service requirement. Debt service refers to the total amount any firm or company needs to cover the interest and principal's cost on all debts (loans and bonds) within a complete business year. It is a determining point for companies to increase their credit score and borrow more loans.

Debt service ratio refers to the total debt to total asset a company has, i.e., its interest and principal versus its net income. It is calculated and summed in decimal or percentage. Lending firms use it to determine a company's borrowing capacity. The lower the debt ratio to total asset, the higher value a company can borrow.

Debt service requirement refers to the overall amount a company needs to have within its debt service fund to cover all liabilities within the fiscal year. This value is a total of all debt (bond and loans interest and principal) annual to be made at the end of the business year.