Debt Service Coverage Ratio is the cash flow coverage ratio of debt payments, one of the most important indicators in project financing, which is also used in a wider range of corporate lending. Here you can get more in formation about DSCR loans in North Carolina.
A sufficient DSCR value provides a margin of safety for the company in repaying the loan, and for the bank it creates such lending conditions under which the risk associated with the borrower will be at an acceptable level.
The idea of using DSCR
If the payment schedule for an investment loan stipulates that all the money earned goes to repay the loan and pay interest, then any decrease in the project’s income will lead to the fact that the company will have to adjust payments to the bank. But such a situation cannot suit the bank; debt financing usually relies on a rigid, predetermined payment schedule that must be adhered to regardless of fluctuations in the borrower’s business.
Therefore, the bank sets a limit that regulates that only part of the free money that the company can use to pay interest and the body of the debt according to the plan can be included in the payment schedule. The remaining funds in each forecast period remain at the disposal of the company, and it will be able to use them to comply with the bank’s payment schedule, even if the project’s income falls below the plan.
How to calculate DSCR
Formula for calculating DSCR used in project finance, where:
CFADS is the cash flow available to service debt.
P – planned principal repayments
I – interest on the loan, which will have to be paid in the corresponding period
The DSCR indicator is calculated separately for each period in which debt repayment is provided.
Because the CFADS-based option requires a cash flow statement, the DSCR calculation is sometimes simplified and presented, for example, as follows:
This approach does not take into account fluctuations in working capital, income tax payments, inflows of financing from other sources. In practice, however, when lending to an investment project, it gives a close result for the following reasons:
The repayment of the loan begins after the start of operations. By this time, working capital is usually already formed and changes slightly.
Income tax is significantly reduced due to interest on the loan. Some amount remains, but this error can be easily taken into account by slightly increasing the requirement for the DSCR value.
When planning project financing, loan repayment is almost never based on refinancing with a new loan or returning the loan from shareholder contributions. Therefore, the forecast project budget will most likely not include an inflow of financing available to repay the loan.
Nevertheless, the variant using CFADS should be considered the main DSCR formula.
DSCR value requirements
In order for loan payments to be balanced with the expected income of the company, the DSCR value should not be lower than 1 in any of the debt repayment periods. Although DSCR<1 does not mean insolvency, as the company may have a sufficient supply of cash generated in previous periods, but such a coverage value means that the planned debt repayment schedule does not take into account the expected development of the project.
As a rule, the requirement for the DSCR value is set by the bank. Here are some examples of such restrictions:
- DSCR>1.1 – for projects where the reliability of the predicted cash flows is very high, or the bank is a participant in the project;
- DSCR>1.2 – in some large or guaranteed projects, as well as for individual industries (for example, for regulated industries, where both consumption and prices can be predicted with a high degree of confidence);
- DSCR>1.4 is the most common coverage requirement in live plant projects;
- DSCR>1.5 is a condition that banks often include in their offers of loan products for project financing, that is, in cases where a loan is attracted to create production from scratch.
The requirements for the DSCR value may be higher. As a general rule, the higher the uncertainty and risks affecting the project’s cash flows, the higher the DSCR value should be.