How Debt Service Cover Ratio is used in Project Finance?
By: Greg Ahuy
Date: June 15, 2021
In this article, we will review the debt service cover ratio in project finance.
The debt service cover ratio is widely used in project finance models, and, it is a debt metric used to analyze the project’s ability to repay the debt.
You may have heard about the debt service cover ratio in corporate finance, which is a ratio of EBITDA to debt service.
However, in project finance, the definition of DSCR is Cash Flow Available for Debt Service or CFADS divided by the debt service.
DCSR is a ratio generated by the project, and then, this project’s DSCR is compared to the target or required DSCR set by the lenders.
DSCR reflects the ability of the project to service the debt. High DSCR generated by the project means that the project is generating cash flows that significantly exceed the debt principal and interest payments. It is possible in such a situation to increase the leverage of the project.
DSCR below 1 means CFADS is insufficient to cover debt service, and as a result, the project’s debt has to be reduced to reduce the debt service.
It should be noted that DSCR is a forward-looking metric, and, it is based on the projected cash flow numbers. And, if the projections are made incorrectly, the DSCR will also be incorrect.
Typically, the loan agreement will specify in financial covenants the minimum required DSCR, along with other ratios that the project shall meet.
After the financial close, the lenders will use these ratios as part of the project monitoring and control functions.
Where ratios do not achieve the levels required, the lenders will have a series of possible interventions including blocking dividend distribution, sweeping cash from existing accounts, applying reserve account money to debt service.
If these breaches persist, eventually, they will lead to the default, permitting the lenders to cancel outstanding loan amounts or suspended existing loans. It may also permit the lenders to increase the interest margin, require compensation for additional investigation costs, and/or other fees and fines.
Therefore, those ratios are extremely important.
So, let’s review how the current DSCR is calculated.
The first ingredient in the current DSCR calculation is CFADS over debt repayment term, and note that this is a 6 month period timeline.
Then, we need our debt service, which is the debt principal repayment and interest expense.
And the DSCR formula is CFADS divided by the debt service, and we have to select the lowest DSCR that our project produces during the debt repayment term to calculate the minimum DSCR.
Then, we have to compare the lowest project’s DSCR to the lender’s required DSCR.
If the lowest project’s DSCR is above the required DSCR, then the project meets the lenders’ requirements.
In this article, we learnt about the debt service cover ratio in project finance transactions. To learn about financial modelling for project finance please enroll in our courses.
Learn more about DSCR by watching this short video