Debt Service Reserve Account

The Debt Service Reserve Account provides additional security for lenders as it acts as a cash buffer during periods of weak cashflows. In this tutorial, we learn how the DSRA/c links to the Financial Statements and how to model the DSRA/c in a Project Finance Model.

What is the purpose of DSRA/c

The Debt Service Reserve Account (“DSRA” or “DSRA/c”) is generally a deposit which covers a set number of periods of projected debt service obligations. The majority of project finance transactions would have a requirement for a DSRA/c in the Project’s Term Sheet.

The purpose of the DSRA/c is to provide additional security in periods when Cash Available for Debt Service (“CFADS”) is less than the scheduled principal and interest payments. This provides a cash buffer during periods, for example, when there are operational issues to be resolved and / or in more extreme circumstances, such as debt restructuring prior to borrower default.

Characteristics of DSRA/c

The DSRA/c covers the interest and principal repayments of the debt service obligation and is generally funded up to a target balance. The target balance would be set out in the Project’s Term Sheet and would generally be set at three, six, nine or twelve months or for possibly a fixed period of time.

Additionally, the Term Sheet would state the funding method to establish the DSRA/c and could include one of the following:

• Funded in full on the last day of Construction;
• Partially funded on the last day of Construction, then built-up from the Project’s Cashflows; or
• Completely built-up from the Project’s Cashflows.

A DSRA/c has two modes of operation:

Linking DSRA/c to the Financial Statements

The position of the DSRA/c in the Financial Statements is illustrated in Screenshot #1. The Cash Available to Fund DSRA/c comes after Debt Service in the cashflow waterfall and is ranked higher than Payments to Equity, thus providing an additional level of security for the lenders. The DSRA/c cash inflows (additions) and outflows (releases) are linked to the cashflow waterfall, and in this example, the initial funds used to establish the DSRA/c are positioned before Debt Funding as it is debt-funded. The DSRA/c closing balance is included under Current Assets in the Balance Sheet.

 Screen shot #1: Linking the DSRA/c to the Financial Statements

Application of DSRA in a Project Finance Model

The DRSA/c includes cash inflows which are additions to the account built up from the Project’s Cashflows, and cash outlflows, which are cash releases when there is excess cash or during periods of distress. When modelling the DSRA/c in a project finance model, the formulae for calculating the DSRA/c cash inflows and outflows are linked with the Project’s Cashflows and the DSRA/c itself. The DSRA/c cashflows are described below.

Screen shot #2: Calculation of DSRA/c

DSRA/c Cash Inflows (additions) include:

• Initial Funding of DSRA: The funding methods available to establish the DSRA/c are described above.
• Funding from Cashflow: This is funding from the Project’s Cashflow (using Cash Available to Fund DSRA/c) to top-up the DSRA/c to the Target Balance.

DSRA/c Cash Outflows (releases) include:

• Release to Cashflow (during distress): This is the cashflow release from the available balance in the DSRA/c to fund the shortfall in CFADS.
• Release to Cashflow (excess cash released): This is the release from the DSRA/c to reduce the balance down to its Target Balance, including the release on final maturity.

Screenshot #2 illustrates the modelling of the DSRA/c in a Project Finance Model. In this example, the Initial DSRA/c is debt-funded on the last day of Construction and the target balance is equal to the next three months of debt service. A binary flag is used to check if the DSRA/c is fully funded during the debt term (this flag is commonly linked to the Equity distribution test). Additionally, interest is earned on the opening balance of the DSRA/c and is recognised in the same way interest on cash balance is in the cashflow waterfall.

Modelling the DSRA/c: the Do’s and Don’ts

The core logic of the DSRA/c is not circular but care should be taken when building the DSRA/c to avoid circular references. This is particularly the case if the initial balance is debt-funded during the construction period. Also, calculating the Target Balance using the debt service for the next period could result in a circular reference if Interest on the DSRA/c is being considered. This can be avoided by using a macro or other modelling techniques, which are often a reasonable approximation.

It is important to verify if the DSRA/c calculations are producing sensible results in the Base Case as well as in other Scenarios. This is especially the case in Downside Scenarios where the DSCRs fall below 1.0x. For example:

• The DSRA/c balance should always be positive.
• Funding from the Project’s Cashflows to top-up the DSRA/c should not exceed the Cash Available to Fund DSRA/c.
• The cash inflows and cash outflows from the DSRA/c should not occur concurrently.
• In the Base Case, the DSRA/c movements should be minimal except for the initial funding and the final release.
• The sum of all cash movements plus Initial Funding should equal zero.
• At the end of the loan life, the DSRA/c balance should be zero and should steadily decline in the periods leading up to this point.
• During a period of distress, a release from the DSRA/c should only be sufficient to maintain a DSCR of 1.00x.