You run IHeartCholesterol, a 100-store pizza chain. You have no debt and small cash amounts. You have used extra cash historically to buy or open additional pizza parlors.
But now along comes MetabolismKillers, a chain of 40 pizza parlors. They want 20 million bucks for you to buy all of them, and the parlors themselves currently produce each year about a million bucks in cash. You think that, with your buying leverage of cheese and dough and oven rentals, you could make the acquisition produce cash flow of a million-and-a-half bucks in Year One just by virtue of lowering expenses on volume purchases of the stuff you put on the pizzas.
Minor problem: You don't have 20 million bucks laying around. Your own existing business has cash flow of about $3 million a year. Combined, you'd have $4.5 million a year in cash flow, and that should be enough to quickly pay off the Acquisition Financing of $20 million you want to raise from your kindly loving bankers, who are all too happy to loan you the money at onerous terms.
If things go well, you grow great; if they don't, the financiers likely take ownership of your pizza chain and all your hard work is wizzed away, like the soda you drank three hours ago.
Related or Semi-related Video
Finance: What are Debt Service and Debt ...3 Views
Finance, a la shmoop. What is debt service and debt service ratios? Well debt
service is just the interest you pay on debt in a given year. Like you're [Definition written on a 100 dollar bill]
servicing the debt, like think about the oil demanded by a robot in a year she
demands to be serviced and the oil you serve her will you know quench her [Robot drinking oil]
thirst. Well debt service can be easy or it can
be hard, like whatever.com has 50 million bucks of 6 percent debt costing 3 [The debt service calculation is shown]
million a year to service. Well if whatever.com had 40 million bucks in [Vault full of money]
cash profits servicing its debt would then be easy and it would have a debt [Someone repeatedly pressing an easy button]
service ratio of 40 over 3 or 13 and 1/3 times coverage. Said another way the odds [The ratio calculation is shown]
that whatever.com would find itself in a position that it couldn't service
its debt are well very low. But think about the other side of the coin if [Somone about to flip a coin]
whatever.com had only 4 million dollars in cash profits well then it's debt
service ratio is 4 over 3 meaning that 75% of its cash flow leaves the company [Money going from whatever.com to the lenders]
and goes into the coffers of the kindly loving lenders who are nervous about the
company falling into default and going bankrupt which does not make the oil go
down easy... [Robot drinks oil and spits it out]
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