DEBT SERVICE RATIO
1. Context
According to the RBI, household debt surged to 5.8 per cent of the GDP in FY23, marking the second-highest annual increase since Independence (the highest growth was at 6.7 per cent of GDP in FY07). Despite intense debate over the drivers of this surge, there is no discussion about the sustainability of such a rise in household debt.
2. About household debt
- Household debt is the total amount of debt owed by individuals and families. It can include mortgages, credit card debt, student loans, car loans, and other types of debt.
- Household debt can be secured or unsecured. Secured debt is backed by collateral, such as a home or car.
- Unsecured debt is not backed by collateral, such as credit card debt.
- For Example, Mortgages, Credit card debt, Student loans, Car loans, Personal loans, Payday loans, Medical debt, Retail debt, Utility bills, Phone bills and Other bills and expenses.
3. Household debt in India
- The household debt-to-GDP ratio in India was 35.56% in 2023. This means that Indian households owe 35.56% of the country's GDP in debt.
- The household debt-to-GDP ratio in India has been increasing in recent years, due to factors such as rising housing prices and increased access to consumer credit.
- The Reserve Bank of India (RBI) and other financial institutions monitor household debt levels in the country.
- Household debt itself is not considered part of a country's Gross Domestic Product (GDP).
- GDP measures the total economic output of a nation, including the value of goods and services produced.
- Household debt reflects the financial obligations of individuals and families, which is a liability.
- However, the financial transactions and spending associated with household debt, such as buying homes or consumer goods, can contribute to GDP indirectly through consumption and investments.
4. About Debt service ratio (DSR)
- The debt service ratio (DSR) is a measure of how much of a household's income is used to pay debt payments.
- It is calculated by dividing total monthly debt payments by monthly income. A DSR of 36% or less is generally considered to be healthy.
Calculation of DSR:
Total Monthly Debt Payments: ₹1, 000
Monthly income: ₹5,000
DSR: ₹1, 000 / ₹5,000 = 20 %
- A DSR of 20% means that the household is using 20% of its income to pay debt payments.
- This is a healthy level of DSR, as it leaves the household with plenty of income to cover other expenses and save for the future.
- However, a DSR above 36% could indicate that the household is at risk of financial distress.
- If a household has a high DSR, it may have difficulty making debt payments if its income decreases or its expenses increase.
5. Debt-service Coverage Ratio (DSCR)
- The debt-service coverage ratio (DSCR) is a measure of a company's ability to meet its debt obligations. It is calculated by dividing net operating income by total debt service, which includes principal and interest payments. A higher DSCR indicates that a company has more cash flow available to pay its debt, while a lower DSCR indicates that the company may be at risk of defaulting on its debt obligations.
- DSCR is an important metric for both lenders and investors. Lenders use DSCR to assess a company's creditworthiness and to determine the interest rate and terms of a loan. Investors use DSCR to assess a company's financial health and to make investment decisions.
- A good DSCR depends on the company's industry, competitors, and growth. However, a DSCR above 1.25 is generally considered to be strong, while a DSCR below 1.00 could indicate that the company is facing financial difficulties.
5.1. The advantages and disadvantages of using DSCR
Advantages
- Can be calculated over a period of time to better understand a company's financial trend.
- May be used to compare operational efficiency across companies.
- Includes more financial categories (i.e., principal repayments) than other financial ratios.
- Maybe a more comprehensive analysis of a company's financial health as it is often calculated on a rolling annual basis.
Disadvantages
- May not fully incorporate a company's finances as some expenses (i.e., taxes) may be excluded.
- Has heavy reliance on accounting guidance which may widely vary from the actual timing of cash needs.
- Maybe consider a more complex formula compared to other financial ratios.
- Does not have consistent treatment or requirement from one lender to another.
6. Conclusion
The surge in household debt in India highlights the need for responsible lending practices and ongoing monitoring to ensure financial stability. Both households and businesses should carefully manage their debt obligations to maintain a healthy financial position and avoid potential financial distress.
|
For Prelims: household debt, debt-service coverage ratio, debt-service ratio, Gross Domestic Product, RBI,
For Mains:
1. Examine the concept of the Debt Service Ratio (DSR) and its significance in evaluating the financial health of households. How does a high DSR affect a household's financial stability, and what measures can be taken to manage it effectively? (250 words)
|
|
Previous Year Questions
1. In the context of the Indian economy, non-financial debt includes which of the following? (UPSC 2020)
1. Housing loans owed by households
2. Amounts outstanding on credit cards
3. Treasury bills
Select the correct answer using the code given below:
A. 1 only B. 1 and 2 only C. 3 only D. 1, 2 and 3
Answer: D
2. Consider the following statements: (UPSC 2019)
1. Most of India's external debt is owed by governmental entities.
2. All of India's external debt is denominated in US dollars.
Which of the statements given above is/are correct?
A. 1 only B. 2 only C. Both 1 and 2 D. Neither 1 nor 2
Answer: D
3. What is Debt Service Ratio? (UGC NET Geography 2022)
1. It is the proportion of a country's export earnings that it needs to use to meet its debt repayment
2. It is the proportion of a country's total national income that it needs to use to meet its debt repayment
3. It is the proportion of a country's income from services sector that it needs to use to meet its debt repayment
4. It is the proportion of a country's total income from manufacturing sector that it needs to use to meet its debt repayment
Answer: A
4. Debt Service Coverage Ratio indicates which one of the following? (UGC NET Management 2018)
A. Effective utilisation of assets.
B. Number of times fixed assets cover borrowed funds.
C. Excess of Current Assets over Current Liabilities.
D. Number of times surplus covers interest and instalments of Term Loans.
Answer: D
5. With reference to Indian economy, consider the following statements: (UPSC 2015)
1. The rate of growth of Real Gross Domestic Product has steadily increased in the last decade. 2. The Gross Domestic Product at market prices (in rupees) has steadily increased in the last decade. Which of the statements given above is/are correct? (a) 1 only (b) 2 only (c) Both 1 and 2 (d) Neither 1 nor 2 Answer: B
6. A decrease in tax to GDP ratio of a country indicates which of the following? (UPSC 2015) 1. Slowing economic growth rate 2. Less equitable distribution of national income Select the correct answer using the code given below: (a) 1 only (b) 2 only (c) Both 1 and 2 (d) Neither 1 nor 2 Answer: A
7. With reference to the Indian economy, consider the following statements: (UPSC 2022)
1. An increase in the Nominal Effective Exchange Rate (NEER) indicates the appreciation of the rupee.
2. An increase in the Real Effective Exchange Rate (REER) indicates an improvement in trade competitiveness.
3. An increasing trend in domestic inflation relative to inflation in other countries is likely to cause an increasing divergence between NEER and REER.
Which of the above statements are correct?
A. 1 and 2 only B. 2 and 3 only C. 1 and 3 only D. 1, 2 and 3
Answer: C
8. Consider the following statements: (UPSC 2021)
1. The Governor of the Reserve Bank of India (RBI) is appointed by the Central Government. 2. Certain provisions in the Constitution of India give the Central Government the right to issue directions to the RBI in the public interest.
3. The Governor of the RBI draws his natural power from the RBI Act.
Which of the above statements is/are correct?
A. 1 and 2 only B. 2 and 3 only C. 1 and 3 only D. 1, 2 and 3
Answer: C
|
Source: Investopedia
