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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
- DSCR definition in project finance
- Applications of DSCR in project finance
- Breaching a DSCR covenant
- Points to keep in mind when calculating a DSCR
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The Debt Service Coverage Ratio (DSCR) is the most widely used debt ratio within project finance. It is used to size and sculpt debt payments, to assess whether equity distributions should be restricted and to determine if the project is in default. Every analyst needs to know how to model and review the DSCR.
A typical definition of a DSCR for senior debt is as below:
This calculates how many times the cash flow can repay the debt service over a set timeframe.
The need for the ratio
Cash Flow Available for Debt Service (CFADS) is used as the numerator, not EBITDA or Net Operating Income as we are focused on cash flow in project finance, not accounting measures.
Typically the DSCR is used:
- Before financial close – to determine the size of the loan that the senior lenders will make available (“debt sizing”), and to calculate each loan repayment over the life of the project to match size of each repayment to the cash generated in that period (“debt sculpting”).
- After financial close – to determine if the project’s CFADS generated are weak enough to warrant the suspension of payments to equity (“lock-up”) or worse, which may trigger an event of “default”.
There are a number of variations of the DSCR to be aware of.
- A Periodic DSCR is calculated using CFADS generated and debt payments made, over one debt payment period. Typically this could be quarterly or semi-annually (common for bonds or development banks);
- An Annual ADSCR is calculated in the same way, but considers the CFADS and Debt Service over a 12 month period, averaging out any ups and downs over the two or more debt payment periods it contains.
- A DSCR or ADSCR may be backward looking (considering CFADS and debt service that have already occurred, often labelled HDSCR & HADSCR) or forward looking, using forecast information (FDSCR & FADSCR).
Let’s take a project that has a constant revenue stream over time, but with variable cost profile, producing a profiled CFADS. Our project currently has a ‘mortgage style’ annuity repayment. The means our DSCR is also a lumpy profile over the project, even going below 1.00 in two years.
By Rickard Wärnelid
The Term Sheet will define the DSCR and this is one of the core drivers of the debt sizing for the project and assesses the ability of the project to repay its debt. The debt repayments need to match the cashflow profile to avoid having periods where there is not enough actual cashflow to repay the debt.
The illustration below shows the proportions of Cashflow. Available for Debt Service compared to Total Debt Service (Interest + Principal) for a project before it has adjusted its debt repayments based on the DSCR.
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 cashflows from the project due to, for example, operation inefficiencies post the end of construction.
What does it affect ?
Sculpted debt repayments
The DSCR in the above example varies from 1.2 to 1.8. But our term sheet specifies a target (minimum) DSCR of 1.30x. This shows that in some periods we are paying more than we should and in other periods less. We need to sculpt our debt repayments during structuring of the project to this target ratio to avoid overloading one particular period. Once this is done, we will have a constant DSCR forecasted ensuring that a lower principal repayment is applied in a period with lower CFADS. Once sculpting is completed at the structure stage, the repayments are fixed for the project.
Lock – Up and Default
Once in operation the lenders will assess the ratios against the minimum levels for lock-up and default (set at lower levels to the ratio used at the structuring phase). These ratios are typically assessed on a 12 month look back and look forward basis to average out the effect of one or two periods. Clearly the look-back ratio is the only one we really know as the look forward is still a forecast on CFADS.
A DSCR of less than one means that the cashflows from the project are not strong enough to support the level of debt.
In our example we have ignored other lenders fees beyond interest. Other types of lenders fees include:
- Bank agency fees
- Net payments based on swap agreement
- Other Debt related fees (if not included as project’s operating cost)
Breaching a DSCR covenant
Screenshot #2 illustrates a graph highlighting a weak cashflow in the last period (June 2022) of a project where the DSCR drops below the Term Sheet DSCR Covenant of 1.30x. The value is 1.2x, which means the project is in lock-up or default.
Implications of breaching DSCr
If the project’s DSCR falls below the lock-up value due to an insufficient cash flow, distributions to shareholders are prevented until adequate funds are available in order to allow the DSCR to return above the lock-up threshold. If default is reached, the lender can require its debt to be repaid or even take over control of the project (instead of the shareholders).
Some other items to be aware of when calculating the DSCR:
- DSCR measures how many times the CFADS can repay the Scheduled Debt Service.
- Sculpting is only done at the structure phase, once complete the repayments are set and the DSCR is reviewed for lock-up and default
- It can be volatile over periods due to (for example) one late payment, so it is often calculated on a 12 month look-back or look-forward basis to average out this effect
- Only include scheduled debt payments. If there is a cash sweep it should be excluded
- Mezzanine or junior debt may calculate the ratio in the same way but based on the cash available for junior debt service, or with CFADS and total junior + senior debt service Bank agency fees.