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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.
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.
There are a number of variations of the DSCR to be aware of.
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.
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.
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:
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.
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:
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