A Debt Service Fund is referred to as a cash reserve that is maintained by the organization in order to pay its dues and obligations on time. These dues and obligations mainly take the form of principal and interest payments on certain types of debt.
The main reason for the creation of the debt service fund is mainly directed towards reducing the risk of not being able to pay their debts and funds in due time.
In this aspect, when investors find out that the organization (or the party that is lending the respective amount) is maintaining a debt service fund, it acts as an attraction for them, essentially because it reduces the likelihood of them not being paid in time.
From the perspective of the lending party, the debt service fund is in place because it significantly reduces the effective interest rate.
Debt Service is considered to be an important metric from the perspective of external stakeholders because it provides useful insights regarding the company’s leverage. This helps the investors or the creditors to ensure that the lending party is going to be able to pay their previous outstanding obligations, in addition to these new ones.
This implies that the company would be able to carry the high debt load because they have consistent and reliable profits that would help to service the required debt.
Example of Debt Service Fund
The concept of Debt Service Fund can be illustrated using the following example:
Dewberry Co. has taken on long-term loans from Major Inc. and Imperial Co. for $150,000 and $200,000 respectively at a rate of 10% each. The loan from Major Inc. needs to be repaid full and final after 3 years, and the loan from Imperial Co. needs to be repaid after 2 years. It requires yearly installments to be paid, along with interest for both parties.
It is essential to consider the fact that year-end payments need to be made, along with the interest. Dewberry Co. needs to plan their expenses in order to make sure that they are able to meet all yearly payments so that their credit rating does not hamper. Therefore, they decided on making a debt service fund.
Under this particular fund, they decided to add amount to this account every month, as a reserve set aside to meet the yearly payments. In this regard, it was rudimentary to ensure that this was perpetually replenished, so that year end payments were not a cause of concern.
In the example above, it can be seen that Dewberry Co. created Cash Reserve Fund in order to ensure that Dewberry Co., on an average manages to deposit the amounts that, upon aggregation, would amount to the principal and the interest payable.
How Does Debt Service Fund work?
Taking on debt or long-term loan is a normal practice for a lot of companies. However, before they approach the respective banks and lenders, the firm needs to compute their debt service coverage ratio. This ratio is extremely resourceful in determining the underlying ability of the borrower to make subsequent debt payments.
This is because this ratio draws a comparison between the net operating income and the outstanding interest payments (both, principal and interest). Therefore, the lender analyses the given situation and determines if there are enough earnings generated that can ensure that debt can properly be serviced.
After these calculations have been duly made, the investor looks at the debt service fund, and if it is duly maintained by the company. From the generated earnings of the company, the company continues to set aside this particular amount to set aside for payment of debt.
This fund continues to be replenished unless the amount is paid. It is used for that specific purpose only so that these reserve funds are not used elsewhere in the business.
Journal Entries of Debt Service Fund
Debt Service Fund is referred to as an internal arrangement within the company that simply transfers the amount from one account to another. In order to record the transfer of funds from the bank to the debt service fund, the following journal entries are made:
|Debt Reserve Fund||xxx|
Since Debt Reserve Fund is a fund that is created within the resources from the bank, it continues to be an asset account. Subsequently, when the amount is withdrawn from the Debt Reserve Fund to be paid off the debtors, the following transaction is made:
|Loan Settlement (Outstanding Debt)||xxx|
|Debt Reserve Fund||xxx|