This tutorial focuses on the debt service coverage ratio (DSCR), which is widely used in project finance models. It is a debt metric used to analyse the project’s ability to repay debt periodically.
DSCR = cash flow available for debt service / debt service (principal + interest)
Definitions of DSCR
There are other definitions of DSCR that are used in fields outside project finance:
In corporate finance, it refers to the amount of cash flow available to meet annual interest and principal payments on debt, including sinking fund payments.
In government finance, it is the amount of exporting earnings needed to meet annual interest, and principal payments on a country’s external debts.
In personal finance, it is a ratio used by bank loan officers in determining income property loans. The ratio of over 1.0 x would mean the property is generating enough income to pay its debt obligations.
DSCR definition in project finance
In project finance modelling, cash flow available for debt service (CFADS) is used as the numerator, rather than earnings before interest, tax, depreciation and amortisation (EBITDA) or net operating income, which is used in corporate finance modelling.
The DSCR can be calculated using several different methods
Quarterly CFADS/quarterly debt service
Semi-annual CFADS/semi-annual debt service
Annual CFADS/annual debt service
Backward and forward looking CFADS and debt service (e.g., six month look-back or (x) periods look-back ; six month look-forward or (x) periods look-forward)
Applications of DSCR in project finance
The term sheet definition of DSCR drives the debt sizing of the project. When performing debt sizing analysis based on ratios that are defined as the average DSCR over several periods, it is important to keep in mind that sizing performed purely using DSCR can result in periods where there is not enough actual cash flow to repay debt.
In these more complicated scenarios a VBA script is usually the only way to solve the problem, but correctly implemented this can be made very transparent and efficient.
With CFADS significantly larger than debt service, it is clear that there is a significant buffer in the project to protect the lenders from decreased cash flows due to, for example, operational inefficiencies post the end of construction.
Debt sizing considerations – DSCR < 1.00x
A DSCR of less than one means that the cash flows from the project are not strong enough to support the level of debt.
In a debt sizing phase of a project, this could be managed by using one of the following structures. Be careful when modelling around a DSCR < 1.00x – this is such a fundamental issue that correct approach needs careful consideration. If a senior facility does not allow for capitalisation of unpayable sums, do not model it that way.
This will ensure that a lower principal repayment is applied in a period with lower cash flow available for debt service (CFADS). Please refer our debt sculpting tutorial, on debt sculpting to achieve a target DSCR.
A grace period is the number of months or years in the beginning of the debt term where there is no obligation by the borrower to repay debt. This is particularly common in projects where there is a ramp-up phase, such as toll roads and other types of infrastructure projects.
Debt service reserve account (DSRA/c)
A debt service reserve account (DSRA or DSRA/c) works as an additional security measure for the lender, as it ensures that the borrower will always have funds deposited for the next ‘x’ months of debt service. Commonly the debt service reserve account target is defined as six or 12 months of debt service.
Points to keep in mind when calculating a DSCR
The DSCR is a key project finance ratio which is calculated during the debt term
DSCR measures how many times the CFADS can repay the scheduled debt service
Usually DSCR is calculated in every period
Identification of the minimum DSCR is the primary method to identify a period of weak CFADS to service the debt obligations
However, when DSCR is measured in every period, the DSCR can be a volatile measure and may fluctuate from period to period
To counter this effect the DSCR is often calculated on a look-back rolling basis, e.g., 12-month or 4-quarter look-back. In every period the CFADS and debt service of the current quarter and the preceding three quarters are compared
The DSCR (‘x’ periods look-back) may produce a smoother, less sensitive DSCR
Please note that a DSCR (per period) could have a DSCR of < 1.00, but a rolling 12-month measure would mask this.
Corality Training Academy - SMART CAMPUS
There are numerous other tutorials and free resources related to financial modelling in Corality's SMART Campus.
Some of the more popular courses that relate to this topic include:
Financial Modelling for Power Generation Projects
Best Practice Project Finance Modelling