Debt Service Capacity

What is debt service capacity?

Debt service capacity (German: Kapitaldienstfähigkeit) refers to a company's ability to meet its debt service, that is, interest and loan repayment on all financing, on a lasting basis out of ongoing business. It is measured by the ratio between the cash flow available for debt service and the debt service owed. In private life, this corresponds to the question whether the monthly loan instalment can be paid from salary or only by drawing down savings.

Debt service capacity is at the centre of every lending decision. Banks see in it the actual source of repayment of a loan; collateral is meant to come into play only if this source dries up. It is examined when the loan is granted and on an ongoing basis during its term, often as a key figure in the covenants, the conditions of the loan agreement. It carries particular weight in acquisition financing, that is, loans for a company purchase that are repaid from the future cash flows of the acquired company.

Debt service limit, coverage ratio and surplus or shortfall

Three terms are often confused in practice:

• Debt service limit (Kapitaldienstgrenze): the absolute amount in euro that a company can at most raise from its ongoing business for interest and repayment.
• Debt service coverage ratio: the ratio of the debt service limit to actual debt service, also known in German as Schuldendienstdeckungsgrad and in English as the Debt Service Coverage Ratio (DSCR). A value of 1.0 means that the available cash flow exactly covers the debt service.
• Surplus or shortfall: the difference between debt service limit and debt service in euro. A surplus is the buffer for weaker years or additional financing.

Formula: debt service coverage ratio = debt service limit ÷ debt service (interest + repayment)

A coverage ratio below 1.0 means that the debt service can be paid only from the asset base, from new loans or from equity. Banks do not look at the expected value alone: they also run a cautious case and check whether coverage stays above 1.0 even if earnings decline.

Calculating debt service capacity: the banks' scheme

There is no uniform definition; the bank and the loan agreement set the calculation steps. A derivation from the annual financial statement is widespread among medium-sized companies:

• Net income for the year
• plus depreciation and amortisation
• plus interest expense on the financing under consideration
• plus or minus the change in long-term provisions and adjustment for one-off income and expenses
• minus distributions to shareholders, and for partnerships and sole proprietorships the withdrawals including private taxes
• equals debt service limit

Because net income for the year has already been determined after income taxes, taxes are not deducted again. Many banks additionally deduct the replacement investments needed to maintain the asset base. Otherwise an apparent debt service capacity arises that lasts only as long as assets are not renewed. In acquisition and project financing, the starting point is usually EBITDA, earnings before interest, taxes, depreciation and amortisation. Taxes paid, necessary investments and the build-up of working capital, that is, additional money tied up in inventories and receivables, are deducted. The figure determined in this way resembles free cash flow before interest payments. In a spreadsheet such as Excel, the scheme can be set up with one column per plan year, separately for the base case and the cautious case.

Debt service includes interest and repayment of all existing and planned financing. Some banks include lease payments and rents for objects needed for operations, because they have a similar economic effect to a loan, although under the HGB (German Commercial Code) they generally do not appear as a liability. For start-up years without repayment, banks usually calculate with the debt service after those years end, because only then does the full burden begin.

Debt service capacity of young technology companies

Young technology companies with negative cash flow have no debt service limit in the classical sense. A bank can grant them a loan only if other factors make up for the missing earning power. These can be collateral, a liability exemption from the development bank, guarantees or a liquidity reserve from a funding round that arithmetically covers the debt service over the term. Liquidity from equity is, however, a stock that shrinks with every month of loss; the runway shows how long it lasts.

Debt capital becomes a sensible addition once part of the business generates predictable surpluses, for example a base of recurring revenue with a low churn rate. The financing then ties in with that part and is to be sized so that its debt service is covered even without further growth. A loan whose debt service can be met only with the next funding round depends economically on that round. That is the model of venture debt, which is aimed at companies with venture capital backers, not that of a classical bank financing.

Debt service capacity in succession and company sale

In a management buy-out, the purchase of the company by its own management, or another succession solution, the debt service capacity of the target company determines how much bank financing the acquirer can take on. The purchase price financing is serviced from the cash flows of the acquired company. If the purchase price exceeds the sustainable debt, the gap must be closed by equity from the acquirer, a vendor loan or performance-related parts of the purchase price. For sellers, this calculation is as important as for buyers, because it shows which purchase price can realistically be presented with bank financing.

Worked example: calculating debt service capacity

A software company with a maintenance and licence business plans an investment loan of EUR 1.5 million. The term is five years with equal annual repayment instalments, and the interest rate is assumed to be 6% per year. The plan for the coming year provides for EBITDA of EUR 1.5 million, income taxes paid of EUR 290,000 and necessary replacement investments of EUR 300,000; working capital remains unchanged. The bank starts from EBITDA and deducts taxes and replacement investments. Existing loans cause debt service of EUR 310,000, of which EUR 70,000 is interest and EUR 240,000 repayment.

• Debt service limit: EUR 1,500,000 minus EUR 290,000 minus EUR 300,000 = EUR 910,000
• Debt service of the new loan in the first year: repayment EUR 1,500,000 ÷ 5 = EUR 300,000 plus interest EUR 1,500,000 × 6% = EUR 90,000, together EUR 390,000
• Total debt service: EUR 310,000 + EUR 390,000 = EUR 700,000
• Debt service coverage ratio: EUR 910,000 ÷ EUR 700,000 = 1.30
• Surplus: EUR 910,000 minus EUR 700,000 = EUR 210,000
• Cautious case with 20% less EBITDA: the decline of EUR 300,000 reduces the tax burden by around EUR 90,000 to around EUR 200,000.
• Debt service limit in the cautious case: EUR 1,200,000 minus EUR 200,000 taxes minus EUR 300,000 replacement investments = EUR 700,000; coverage ratio EUR 700,000 ÷ EUR 700,000 = 1.00
• Sustainable debt service at a required coverage ratio of 1.25: EUR 910,000 ÷ 1.25 = EUR 728,000; of which free for the new loan EUR 728,000 minus EUR 310,000 = EUR 418,000
• Maximum sustainable loan: in the first year each euro of loan costs 20% repayment and 6% interest, together 26%; EUR 418,000 ÷ 0.26 = around EUR 1.61 million

In the base case, the loan is sustainable with a coverage ratio of 1.30 and lies just below the maximum sustainable amount. The cautious case, however, shows that a decline in EBITDA of a fifth already uses up the entire buffer. In the loan discussion, the stability of the maintenance revenue is therefore in the foreground, along with the question whether a longer term or a repayment-free year can reduce the debt service.

Distinction: debt service capacity, creditworthiness and debt ratio

• Creditworthiness: the overall judgement on credit standing, condensed into a rating. A company can have sufficient debt service capacity for a specific loan and still receive only a medium rating, for example because of low equity or dependence on a few customers.
• Dynamic debt ratio: relates net financial debt (financial liabilities less liquid funds) to EBITDA or cash flow and shows approximately in how many years the debt could be repaid. It does not take the agreed repayment structure into account.
• Interest coverage ratio: relates an earnings figure before interest, usually EBITDA, to interest expense. It ignores repayment and is of little informative value for loans with high repayment.

Common mistakes

• Taxes deducted twice. Anyone who starts from net income for the year and then deducts taxes again calculates the debt service limit too low.
• Limit and coverage ratio confused. The debt service limit is an amount in euro, the coverage ratio a ratio; in a bank meeting, a mix-up is noticed immediately.
• Replacement investments overlooked. A cash flow that is sufficient only without renewing assets does not support a loan in the long run.
• Only the base case calculated. Banks examine the cautious case; anyone who does not present it themselves leaves the assumptions to the bank.
• Existing obligations forgotten. The debt service of current loans, lease payments and shareholder loans with agreed repayment belong in the calculation.
• Distributions not taken into account. Expected distributions and, for partnerships, withdrawals reduce the debt service limit directly.

Frequently asked questions

What debt service coverage ratio is expected?

As a rule of thumb, banks require at least 1.1 to 1.3. The exact threshold depends on the sector, the volatility of earnings, the term and collateral; where earnings fluctuate strongly, banks require more headroom, and for well-secured loans with stable revenue, sometimes less.

Does money from a funding round count?

As liquidity yes, for the debt service limit no. Debt service capacity measures what the ongoing business earns. A high bank balance from a round makes a company solvent but not capable of servicing debt; banks take it into account as a reserve that bridges start-up losses and debt service for a limited time.

What happens if debt service capacity is not given?

Then the bank generally does not grant the loan in the form applied for; at most it offers a smaller amount or demands additional collateral. For existing loans, a breach of covenants threatens. A different structure provides a remedy: a longer term, repayment-free years or a partly bullet repayment reduce the annual debt service. Lower distributions and a higher share of stable recurring revenue raise the debt service limit.

How do banks examine debt service capacity in a property financing?

For private buyers, through a household calculation: net income minus living costs and existing instalments gives the maximum amount available for the new instalment. For let properties, the bank applies the sustainably achievable rent after operating costs and sets it against the debt service, similar to a corporate loan.

Does the bank calculate with actual figures or with the plan?

With both. The starting point is the last annual financial statements and the current business management evaluation; for new loans, the plan over the term is added. If the plan departs sharply from the past, the bank demands a justification and often applies its own discounts.

The Roemer Capital view

Before every financing decision, we separate two questions that Lucas Roemer, in his book “Kapital folgt Struktur” (Capital Follows Structure), distinguishes as capital-ready (kapitalfähig) and investor-ready (investorenfähig). A company is capital-ready if it can service loans out of its business; debt service capacity is the central yardstick for this, supplemented by the debt ratio. It is investor-ready if it is structurally able to grow disproportionately with external capital. The two can diverge, and the answer determines whether debt or equity is the right next step.

Before bank meetings, we calculate the debt service coverage ratio in the base case, the cautious case and the optimistic case of the financial model. In succession and company sales, we derive from this which part of the purchase price can be financed by banks and which would have to be structured through equity from the acquirer or a vendor loan.