{"id":29864,"date":"2024-08-10T17:01:01","date_gmt":"2024-08-10T22:01:01","guid":{"rendered":"https:\/\/breakingintowallstreet.com\/?post_type=biws_kb&#038;p=29864"},"modified":"2025-01-29T23:22:55","modified_gmt":"2025-01-30T04:22:55","slug":"debt-service-coverage-ratio","status":"publish","type":"biws_kb","link":"https:\/\/breakingintowallstreet.com\/kb\/project-finance\/debt-service-coverage-ratio\/","title":{"rendered":"The Debt Service Coverage Ratio (DSCR): Full Guide to a Critical Metric in Project Finance"},"content":{"rendered":"<div id=\"ez-toc-container\" class=\"ez-toc-v2_0_81 counter-flat ez-toc-counter ez-toc-grey ez-toc-container-direction\">\n<div class=\"ez-toc-title-container\">\n<p class=\"ez-toc-title\" style=\"cursor:inherit\">The Debt Service Coverage Ratio (DSCR): Full Guide to a Critical Metric in Project Finance<\/p>\n<span class=\"ez-toc-title-toggle\"><\/span><\/div>\n<nav><ul class='ez-toc-list ez-toc-list-level-1 ' ><li class='ez-toc-page-1'><a class=\"ez-toc-link ez-toc-heading-1\" href=\"https:\/\/breakingintowallstreet.com\/kb\/project-finance\/debt-service-coverage-ratio\/#How_to_Calculate_the_Debt_Service_Coverage_Ratio_and_Cash_Flow_Available_for_Debt_Service\">How to Calculate the Debt Service Coverage Ratio and Cash Flow Available for Debt Service<\/a><\/li><li class='ez-toc-page-1'><a class=\"ez-toc-link ez-toc-heading-2\" href=\"https:\/\/breakingintowallstreet.com\/kb\/project-finance\/debt-service-coverage-ratio\/#Nuances_and_Fine_Print_in_the_Debt_Service_Coverage_Ratio_Definition\">Nuances and Fine Print in the Debt Service Coverage Ratio Definition<\/a><\/li><li class='ez-toc-page-1'><a class=\"ez-toc-link ez-toc-heading-3\" href=\"https:\/\/breakingintowallstreet.com\/kb\/project-finance\/debt-service-coverage-ratio\/#The_Debt_Service_Coverage_Ratio_in_the_Debt_Sculpting_and_Sizing_Process\">The Debt Service Coverage Ratio in the Debt Sculpting and Sizing Process<\/a><\/li><li class='ez-toc-page-1'><a class=\"ez-toc-link ez-toc-heading-4\" href=\"https:\/\/breakingintowallstreet.com\/kb\/project-finance\/debt-service-coverage-ratio\/#The_Debt_Service_Coverage_Ratio_in_Covenant_Analysis\">The Debt Service Coverage Ratio in Covenant Analysis<\/a><\/li><li class='ez-toc-page-1'><a class=\"ez-toc-link ez-toc-heading-5\" href=\"https:\/\/breakingintowallstreet.com\/kb\/project-finance\/debt-service-coverage-ratio\/#What_Debt_Service_Coverage_Ratio_Do_Lenders_Typically_Require\">What Debt Service Coverage Ratio Do Lenders Typically Require?<\/a><\/li><\/ul><\/nav><\/div>\n\n<blockquote><p><strong>Debt Service Coverage Ratio (DSCR) Definition:<\/strong> The Debt Service Coverage Ratio in Project Finance is defined as the Cash Flow Available for Debt Service (CFADS) in One Year \/ Debt Service in One Year, where the Debt Service equals the <em>scheduled<\/em> Interest + Principal Repayments for that year.<\/p><\/blockquote>\n<p>We\u2019ll define <a href=\"https:\/\/breakingintowallstreet.com\/kb\/project-finance\/cash-flow-available-for-debt-service-cfads\/\" target=\"_blank\">Cash Flow Available for Debt Service (CFADS)<\/a> below, but let\u2019s illustrate the DSCR with a simple example first.<\/p>\n<p>Let\u2019s say that the CFADS for an asset such as a solar plant in one year is $150.<\/p>\n<p>The DSCR is 1.50x, which means the asset can support \u201cDebt Service\u201d of $150 \/ 1.50x = $100.<\/p>\n<p>If the Debt balance here is $800 with a 10% Interest Rate, the Interest Expense is $80.<\/p>\n<p>Therefore, the \u201callowed\u201d or \u201csculpted\u201d principal repayment in this period is $100 \u2013 $80 = $20 because this means the total Debt Service will be $100.<\/p>\n<p>You can certainly calculate the DSCR for normal companies, but it is <strong>most common<\/strong> in <a href=\"https:\/\/breakingintowallstreet.com\/project-finance-modeling\/\" target=\"_blank\" rel=\"noopener\">Project Finance &amp; Infrastructure Modeling<\/a>.<\/p>\n<p>Its two primary use cases are:<\/p>\n<ol>\n<li><strong>Sizing and Sculpting Debt<\/strong> \u2013 The simple above illustrates the \u201csculpting\u201d process. We determine the maximum allowed Debt Service in one period, calculate the Interest Expense, and then back into the Principal Repayment based on that. Sizing the Debt in the beginning is trickier (<a href=\"https:\/\/breakingintowallstreet.com\/kb\/project-finance\/debt-sculpting-vs-debt-sizing\/\" target=\"_blank\" rel=\"noopener\">see our separate tutorial<\/a>) but uses related concepts.<\/li>\n<li><strong>Evaluating Credit Risk and Testing Loan Covenants<\/strong> \u2013 For example, if the minimum DSCR is 1.30x, what happens in the Downside Case of your model? Does the DSCR ever fall below that minimum if there are operational problems, equipment wear-and-tear, or high expense inflation? What happens if a key customer cancels its contract?<\/li>\n<\/ol>\n<h3><strong>Files &amp; Resources:<\/strong><\/h3>\n<ul>\n<li><a href=\"https:\/\/youtube-breakingintowallstreet-com.s3.us-east-1.amazonaws.com\/PF\/PF-03\/PF-03-DSCR-LLCR-Slides.pdf\" target=\"_blank\" rel=\"noopener\">The DSCR and LLCR in Project Finance &#8211; Presentation Slides (PDF)<\/a><\/li>\n<li><a href=\"https:\/\/youtube-breakingintowallstreet-com.s3.us-east-1.amazonaws.com\/PF\/PF-02\/PF-02-VBA-Debt-Sizing.xlsm\" target=\"_blank\" rel=\"noopener\">Debt Sizing and Sculpting with VBA\/Macro Support (XLSM)<\/a><\/li>\n<\/ul>\n<h3><strong>Video Table of Contents:<\/strong><\/h3>\n<ul>\n<li><strong>0:00:<\/strong> Introduction<\/li>\n<li><strong>0:42:<\/strong> The Short Version<\/li>\n<li><strong>4:30:<\/strong> Part 1: Debt Sculpting and Sizing Uses (Quick Review)<\/li>\n<li><strong>6:28:<\/strong> Part 2: Additional Items and Complexities<\/li>\n<li><strong>9:24:<\/strong> Part 3: Variable Dates and Discount Rates<\/li>\n<li><strong>11:22:<\/strong> Part 4: Multiple Debt Tranches<\/li>\n<li><strong>12:51:<\/strong> Part 5: The DSCR and LLCR in Covenant Analysis<\/li>\n<li><strong>14:47:<\/strong> Recap and Summary<\/li>\n<\/ul>\n<h2><span class=\"ez-toc-section\" id=\"How_to_Calculate_the_Debt_Service_Coverage_Ratio_and_Cash_Flow_Available_for_Debt_Service\"><\/span><strong>How to Calculate the Debt Service Coverage Ratio and Cash Flow Available for Debt Service<\/strong><span class=\"ez-toc-section-end\"><\/span><\/h2>\n<p>In Project Finance, the Cash Flow Available for Debt Service is typically defined as follows:<\/p>\n<ul>\n<li><strong>Cash Flow Available for Debt Service (CFADS)<\/strong> = EBITDA \u2013 Maintenance Capex +\/- Change in Working Capital \u2013 Cash Taxes<\/li>\n<\/ul>\n<p><img decoding=\"async\" class=\"aligncenter wp-image-29865 size-full\" title=\"Cash Flow Available for Debt Service (CFADS)\" src=\"https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2024\/08\/10165636\/01-CFADS.jpg\" alt=\"Cash Flow Available for Debt Service (CFADS)\" width=\"1825\" height=\"611\" srcset=\"https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2024\/08\/10165636\/01-CFADS.jpg 1825w, https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2024\/08\/10165636\/01-CFADS-300x100.jpg 300w, https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2024\/08\/10165636\/01-CFADS-1024x343.jpg 1024w, https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2024\/08\/10165636\/01-CFADS-768x257.jpg 768w, https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2024\/08\/10165636\/01-CFADS-1536x514.jpg 1536w\" sizes=\"(max-width: 1825px) 100vw, 1825px\" \/><\/p>\n<p>The idea is to say, \u201cHow much cash flow does this asset generate on an <em>ongoing basis<\/em> that is related to <em>just the asset in its current form<\/em>, ignoring future expansions and upgrades?\u201d<\/p>\n<p>We do not subtract the Interest Expense or Principal Repayments here because we\u2019re assessing <strong>how much is available <em>for<\/em> that Debt Service<\/strong>.<\/p>\n<p>In an <a href=\"https:\/\/mergersandinquisitions.com\/lbo-modeling-test\/\" target=\"_blank\" rel=\"noopener\">LBO model<\/a> for a normal company, the \u201cCash Flow Available for Debt Repayment\u201d metric is slightly different.<\/p>\n<p>For example, <em>all<\/em> Capital Expenditures should be deducted \u2013 both Growth and Maintenance \u2013 and the Interest Expense is also deducted.<\/p>\n<p>The definition differs because in the analysis of a normal company, the <a href=\"https:\/\/breakingintowallstreet.com\/kb\/leveraged-buyouts-and-lbo-models\/debt-schedule\/\" target=\"_blank\" rel=\"noopener\">Debt Schedule<\/a> <em>determines<\/em> the total Debt Principal Repayments it can make or how much extra it must borrow.<\/p>\n<p>In other words, these Principal Repayments are not \u201cfixed\u201d in advance \u2013 other than small percentages for tranches like Term Loans \u2013 and are mostly linked to the company\u2019s ability to repay Debt optionally.<\/p>\n<p>By contrast, <a href=\"https:\/\/mergersandinquisitions.com\/project-finance-vs-corporate-finance\/\" target=\"_blank\" rel=\"noopener\">in Project Finance<\/a>, the Interest Expense and Principal Repayments are both <strong>scheduled<\/strong> in advance, so there\u2019s nothing to \u201cdetermine.\u201d<\/p>\n<p>Because of this pre-scheduling, the cash flows and Debt Schedule differ.<\/p>\n<p>\u201cGrowth CapEx\u201d is not deducted because growth initiatives in Project Finance typically have separate funding sources, such as new Debt or Equity raised specifically to fund these efforts (e.g., a new loan to fund the construction of an additional airport terminal).<\/p>\n<p>By contrast, normal companies might re-invest some of their cash flow in new stores, factories, or equipment upgrades and don\u2019t necessarily need separate funding for them.<\/p>\n<p>In the CFADS calculation, many items affect the Cash Taxes, including the Interest Expense, the Depreciation of the asset\u2019s initial price, and the Depreciation of the Maintenance CapEx:<\/p>\n<p><img decoding=\"async\" class=\"aligncenter wp-image-29866 size-full\" title=\"Taxable Income in CFADS\" src=\"https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2024\/08\/10165711\/02-Taxable-Income.jpg\" alt=\"Taxable Income in CFADS\" width=\"1729\" height=\"660\" srcset=\"https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2024\/08\/10165711\/02-Taxable-Income.jpg 1729w, https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2024\/08\/10165711\/02-Taxable-Income-300x115.jpg 300w, https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2024\/08\/10165711\/02-Taxable-Income-1024x391.jpg 1024w, https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2024\/08\/10165711\/02-Taxable-Income-768x293.jpg 768w, https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2024\/08\/10165711\/02-Taxable-Income-1536x586.jpg 1536w\" sizes=\"(max-width: 1729px) 100vw, 1729px\" \/><\/p>\n<p>These relationships may create <strong>circular references<\/strong>, which we can resolve with some simple VBA code for a \u201cCopy\/Paste Macro.\u201d<\/p>\n<h2><span class=\"ez-toc-section\" id=\"Nuances_and_Fine_Print_in_the_Debt_Service_Coverage_Ratio_Definition\"><\/span><strong>Nuances and Fine Print in the Debt Service Coverage Ratio Definition<\/strong><span class=\"ez-toc-section-end\"><\/span><\/h2>\n<p>Several additional items could go into CFADS, such as allocations to Reserve accounts for Maintenance CapEx, Decommissioning CapEx, and Working Capital.<\/p>\n<p>These allocations <strong>reduce<\/strong> the asset\u2019s cash flow because they require the owners to set aside cash flow today to pay for significant expenditures in the future:<\/p>\n<p><img decoding=\"async\" class=\"aligncenter wp-image-29867 size-full\" title=\"Cash Flow Available for Debt Service in a Mining Model\" src=\"https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2024\/08\/10165733\/03-CFADS-Mining.jpg\" alt=\"Cash Flow Available for Debt Service in a Mining Model\" width=\"2081\" height=\"521\" srcset=\"https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2024\/08\/10165733\/03-CFADS-Mining.jpg 2081w, https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2024\/08\/10165733\/03-CFADS-Mining-300x75.jpg 300w, https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2024\/08\/10165733\/03-CFADS-Mining-1024x256.jpg 1024w, https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2024\/08\/10165733\/03-CFADS-Mining-768x192.jpg 768w, https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2024\/08\/10165733\/03-CFADS-Mining-1536x385.jpg 1536w, https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2024\/08\/10165733\/03-CFADS-Mining-2048x513.jpg 2048w\" sizes=\"(max-width: 2081px) 100vw, 2081px\" \/><\/p>\n<p>Also, in some Project Finance models, there are <strong>optional repayments<\/strong> of the Debt principal, like the \u201c<a href=\"https:\/\/breakingintowallstreet.com\/kb\/leveraged-buyouts-and-lbo-models\/cash-flow-lbo\/\" target=\"_blank\" rel=\"noopener\">cash flow sweep<\/a>\u201d concept in LBO models for normal companies.<\/p>\n<p>In other words, if the asset generates $100 in CFADS in one period and spends only $70 on the Debt Service, it could optionally repay Debt principal with the remaining $30.<\/p>\n<p><strong>These optional repayments are NOT part of the DSCR calculation because only scheduled Debt Service counts.<\/strong><\/p>\n<p>Lenders do not necessarily <em>like<\/em> being repaid early because it means they earn less interest and must reallocate their capital, but it depends on the context.<\/p>\n<p>If a project is going \u201coff the rails\u201d (budget overruns, delays, problematic contracts, etc.), the lender might be fine with these early\/optional Debt principal repayments so it can exit its investment more quickly and find something better.<\/p>\n<div class='code-block code-block-11' style='margin: 8px 0; clear: both;'>\n<div class=\"kb-adinsert-modal\">\n    <div class=\"kb-adinsert-top\">\n      <div class=\"media\">\n          <img decoding=\"async\" class=\"alignnone size-full wp-image-28448\" src=\"https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2024\/11\/19235107\/building.png\" alt=\"Project Finance & Infrastructure Modeling\" width=\"128\" height=\"128\" \/>\n      <\/div>\n      <div class=\"content\">\n          <h3>Master Project Finance Modeling for Energy, Transportation, and Mining Assets<\/h3>\n      <\/div>\n    <\/div>\n    \n    <div class=\"full_text\">\n    \t<ul>\n        \t<li>\n            \t<h4>Evaluate infrastructure deals like a pro<\/h4>\n              <p>You\u2019ll evaluate the risks and rewards and make investment recommendations<\/p>\n\t\t\t    <\/li>\n          <li>\n          \t<h4>Master financial modeling<\/h4>\n            <p>Model solar, wind, gas, nuclear, toll road, airport, and mining assets<\/p>\n\t\t\t    <\/li>\n          <li>\n          \t<h4>Complete 8 case studies<\/h4>\n            <p>Build 4 shorter \u201ccrash course\u201d models and 4 detailed \u201con the job\u201d ones\n\n<\/p>\n\t\t\t  <\/li>\n      <\/ul>\n        \n      <a class=\"cta-link orange-button-medium\" href=\"https:\/\/breakingintowallstreet.com\/project-finance-modeling\/\" target=\"_blank\">Full Details<\/a>\n      \n      <a class=\"cta-link orange-button-medium bg-blue\" href=\"https:\/\/biws-support.s3.us-east-1.amazonaws.com\/Course-Outlines\/Project-Finance-Modeling-Course-Outline.pdf\" target=\"_blank\" rel=\"noopener\">Short Outline<\/a>\n    <\/div>\n<\/div>\n<\/div>\n\n<h2><span class=\"ez-toc-section\" id=\"The_Debt_Service_Coverage_Ratio_in_the_Debt_Sculpting_and_Sizing_Process\"><\/span><strong>The Debt Service Coverage Ratio in the Debt Sculpting and Sizing Process<\/strong><span class=\"ez-toc-section-end\"><\/span><\/h2>\n<p>For more details on this point, please see our <a href=\"https:\/\/breakingintowallstreet.com\/kb\/project-finance\/debt-sculpting-vs-debt-sizing\/\" target=\"_blank\" rel=\"noopener\">debt sculpting vs. debt sizing tutorial<\/a>.<\/p>\n<p>But to summarize: If you use the DSCR to size and sculpt Debt, you need to use <strong>Goal Seek<\/strong> in Excel (Alt, A, W, G in the PC version) to size the initial Debt balance such that it reaches $0 by the maturity date or the end of the asset\u2019s life.<\/p>\n<p>For example, let\u2019s say we\u2019ve projected the CFADS for an asset and \u201cguessed\u201d the initial Debt balance at $800.<\/p>\n<p>Then, we calculate the Interest Expense, Max Debt Service, and Debt Amortization in each period based on the interest rate (10%) and the minimum or targeted DSCR (1.50x here).<\/p>\n<p><strong>Max Debt Service<\/strong> = CFADS \/ DSCR, so it is $150 \/ 1.5x = $100 in Year 1.<\/p>\n<p>We \u201cback into\u201d the Max Debt Amortization based on the Max Debt Service minus the Interest Expense this year:<\/p>\n<p><img decoding=\"async\" class=\"aligncenter wp-image-29868 size-full\" title=\"The Debt Service Coverage Ratio (DSCR) and Debt Principal Repayments\" src=\"https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2024\/08\/10165810\/04-DSCR-Debt-Principal-Repayment.jpg\" alt=\"The Debt Service Coverage Ratio (DSCR) and Debt Principal Repayments\" width=\"1609\" height=\"674\" srcset=\"https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2024\/08\/10165810\/04-DSCR-Debt-Principal-Repayment.jpg 1609w, https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2024\/08\/10165810\/04-DSCR-Debt-Principal-Repayment-300x126.jpg 300w, https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2024\/08\/10165810\/04-DSCR-Debt-Principal-Repayment-1024x429.jpg 1024w, https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2024\/08\/10165810\/04-DSCR-Debt-Principal-Repayment-768x322.jpg 768w, https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2024\/08\/10165810\/04-DSCR-Debt-Principal-Repayment-1536x643.jpg 1536w\" sizes=\"(max-width: 1609px) 100vw, 1609px\" \/><\/p>\n<p><strong>The results are not quite correct because we get a 1.52x DSCR in the final year, indicating the initial Debt balance was too low:<\/strong><\/p>\n<p><img decoding=\"async\" class=\"aligncenter wp-image-29869 size-full\" title=\"A DSCR That's Too High in the Final Year\" src=\"https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2024\/08\/10165843\/05-DSCR-Too-High-Initial-Debt-Balance.jpg\" alt=\"A DSCR That's Too High in the Final Year\" width=\"1448\" height=\"1101\" srcset=\"https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2024\/08\/10165843\/05-DSCR-Too-High-Initial-Debt-Balance.jpg 1448w, https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2024\/08\/10165843\/05-DSCR-Too-High-Initial-Debt-Balance-300x228.jpg 300w, https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2024\/08\/10165843\/05-DSCR-Too-High-Initial-Debt-Balance-1024x779.jpg 1024w, https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2024\/08\/10165843\/05-DSCR-Too-High-Initial-Debt-Balance-768x584.jpg 768w\" sizes=\"(max-width: 1448px) 100vw, 1448px\" \/><\/p>\n<p>This means we need to <em>resize<\/em> the initial Debt.<\/p>\n<p>To do this, we can set the balance to a higher number, such as $850, and use Goal Seek in the Year 10 cell to find the initial balance that results in $0 in Year 10.<\/p>\n<p>This is the simplest possible method for Debt Sizing, but it lacks flexibility and is cumbersome to use in models because we need to use Goal Seek whenever anything changes.<\/p>\n<p>It\u2019s smarter to use the <a href=\"https:\/\/breakingintowallstreet.com\/kb\/project-finance\/loan-life-coverage-ratio\/\" target=\"_blank\" rel=\"noopener\">Loan Life Coverage Ratio (LLCR)<\/a> to size the initial Debt, but it requires more setup in Excel and may require VBA if we properly account for the Taxes and Interest.<\/p>\n<h2><span class=\"ez-toc-section\" id=\"The_Debt_Service_Coverage_Ratio_in_Covenant_Analysis\"><\/span><strong>The Debt Service Coverage Ratio in Covenant Analysis<\/strong><span class=\"ez-toc-section-end\"><\/span><\/h2>\n<p>In Project Finance, as in standard corporate-level <a href=\"https:\/\/breakingintowallstreet.com\/kb\/debt-equity\/debt-vs-equity-analysis\/\" target=\"_blank\" rel=\"noopener\">Debt vs. Equity analysis<\/a>, lenders are always more concerned about the <strong>downside risk<\/strong> because their upside is very limited.<\/p>\n<p>At best, they can earn the interest rates on their loans and, for more junior forms of Debt, potentially get a tiny percentage of equity or incentive payment.<\/p>\n<p><strong>But if the project completely fails, they might lose all their money.<\/strong><\/p>\n<p>Therefore, they often use metrics like the Debt Service Coverage Ratio, Loan Life Coverage Ratio, and Project Life Coverage Ratio to evaluate assets and quantify the risk they are assuming.<\/p>\n<p>In some cases, they might even evaluate the initial development of an asset and then adjust the size of the loan based on whether they think the Upside Case, Base Case, or Downside Case is most likely in the operational period.<\/p>\n<p>In other cases, they might assume a fixed loan size and evaluate how much these ratios fall in the downside scenarios.<\/p>\n<p>If there\u2019s serious default risk, they might establish new <strong>covenants<\/strong> that mandate a higher DSCR or LLCR or that require the asset to create a <strong>Debt Service Reserve Account (DSRA)<\/strong> to handle possible cash-flow shortfalls.<\/p>\n<p>Here are a few examples, starting with a solar plant development with a 1.50x DSCR target in the Base Case (i.e., everything goes as planned):<\/p>\n<p><img decoding=\"async\" class=\"aligncenter wp-image-29870 size-full\" title=\"Solar Development Model Base Case - DSCR and LLCR\" src=\"https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2024\/08\/10165921\/06-Solar-Base-Case-DSCR-LLCR.jpg\" alt=\"Solar Development Model Base Case - DSCR and LLCR\" width=\"1994\" height=\"1099\" srcset=\"https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2024\/08\/10165921\/06-Solar-Base-Case-DSCR-LLCR.jpg 1994w, https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2024\/08\/10165921\/06-Solar-Base-Case-DSCR-LLCR-300x165.jpg 300w, https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2024\/08\/10165921\/06-Solar-Base-Case-DSCR-LLCR-1024x564.jpg 1024w, https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2024\/08\/10165921\/06-Solar-Base-Case-DSCR-LLCR-768x423.jpg 768w, https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2024\/08\/10165921\/06-Solar-Base-Case-DSCR-LLCR-1536x847.jpg 1536w\" sizes=\"(max-width: 1994px) 100vw, 1994px\" \/><\/p>\n<p><img decoding=\"async\" class=\"aligncenter wp-image-29871 size-full\" title=\"Solar Development Model Extreme Downside Case - DSCR and LLCR\" src=\"https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2024\/08\/10165947\/07-Solar-Extreme-Downside-Case-DSCR-LLCR.jpg\" alt=\"Solar Development Model Extreme Downside Case - DSCR and LLCR\" width=\"1998\" height=\"1118\" srcset=\"https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2024\/08\/10165947\/07-Solar-Extreme-Downside-Case-DSCR-LLCR.jpg 1998w, https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2024\/08\/10165947\/07-Solar-Extreme-Downside-Case-DSCR-LLCR-300x168.jpg 300w, https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2024\/08\/10165947\/07-Solar-Extreme-Downside-Case-DSCR-LLCR-1024x573.jpg 1024w, https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2024\/08\/10165947\/07-Solar-Extreme-Downside-Case-DSCR-LLCR-768x430.jpg 768w, https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2024\/08\/10165947\/07-Solar-Extreme-Downside-Case-DSCR-LLCR-1536x859.jpg 1536w\" sizes=\"(max-width: 1998px) 100vw, 1998px\" \/><\/p>\n<p>The DSCR is only 1.10x in this Extreme Downside Case, but the lenders anticipated it and used less Debt in the beginning to account for this poor performance.<\/p>\n<p>Even though the DSCR is lower, <em>the asset never falls below the minimum level<\/em>. The numbers at the end look like ~0 or below because the Debt has been completely repaid by then.<\/p>\n<p>These ratios are <strong>more interesting<\/strong> when the Debt is <em>not<\/em> sculpted and sized to match the future cash flows and is instead based on something like an <a href=\"https:\/\/breakingintowallstreet.com\/kb\/accounting\/ebitda\/\" target=\"_blank\" rel=\"noopener\">EBITDA<\/a> multiple.<\/p>\n<p>For example, here are the DSCR, CFADS, and 1.10x minimum DSCR covenant in the Base Case of an airport acquisition and expansion deal:<\/p>\n<p><img decoding=\"async\" class=\"aligncenter wp-image-29872 size-full\" title=\"Airport Model Base Case DSCR\" src=\"https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2024\/08\/10170010\/08-Airport-Base-Case-DSCR.jpg\" alt=\"Airport Model Base Case DSCR\" width=\"1927\" height=\"1112\" srcset=\"https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2024\/08\/10170010\/08-Airport-Base-Case-DSCR.jpg 1927w, https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2024\/08\/10170010\/08-Airport-Base-Case-DSCR-300x173.jpg 300w, https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2024\/08\/10170010\/08-Airport-Base-Case-DSCR-1024x591.jpg 1024w, https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2024\/08\/10170010\/08-Airport-Base-Case-DSCR-768x443.jpg 768w, https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2024\/08\/10170010\/08-Airport-Base-Case-DSCR-1536x886.jpg 1536w\" sizes=\"(max-width: 1927px) 100vw, 1927px\" \/><\/p>\n<p>And here they are in the Downside Case:<\/p>\n<p><img decoding=\"async\" class=\"aligncenter wp-image-29873 size-full\" title=\"Airport Model Downside Case DSCR\" src=\"https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2024\/08\/10170034\/09-Airport-Downside-Case-DSCR.jpg\" alt=\"Airport Model Downside Case DSCR\" width=\"1930\" height=\"1112\" srcset=\"https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2024\/08\/10170034\/09-Airport-Downside-Case-DSCR.jpg 1930w, https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2024\/08\/10170034\/09-Airport-Downside-Case-DSCR-300x173.jpg 300w, https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2024\/08\/10170034\/09-Airport-Downside-Case-DSCR-1024x590.jpg 1024w, https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2024\/08\/10170034\/09-Airport-Downside-Case-DSCR-768x442.jpg 768w, https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2024\/08\/10170034\/09-Airport-Downside-Case-DSCR-1536x885.jpg 1536w\" sizes=\"(max-width: 1930px) 100vw, 1930px\" \/><\/p>\n<p><strong>The asset does not even come close to complying with the 1.10x minimum DSCR in the Downside Case and falls short in several years of the Base Case.<\/strong><\/p>\n<p>Therefore, the lenders in this deal would ask the owner\/acquirer of the airport to significantly reduce the Debt so the asset complies with the 1.10x minimum.<\/p>\n<p>Alternatively, they could also accept lower DSCR numbers but require a much higher interest rate or other terms to compensate them for the risk.<\/p>\n<p><strong>However, there are limits to this, and 1.00x is usually the \u201cbare minimum\u201d for the DSCR in any context because a transportation asset like this one must be able to always service its Debt.<\/strong><\/p>\n<p>It\u2019s not like a high-growth tech company that can just \u201cgrow its way out\u201d of an overly aggressive Debt burden because growth rates in this sector are limited.<\/p>\n<h2><span class=\"ez-toc-section\" id=\"What_Debt_Service_Coverage_Ratio_Do_Lenders_Typically_Require\"><\/span><strong>What Debt Service Coverage Ratio Do Lenders Typically Require?<\/strong><span class=\"ez-toc-section-end\"><\/span><\/h2>\n<p>This varies widely based on the asset type and how much of the revenue is \u201clocked in\u201d by contracts such as Power Purchase Agreements (PPAs) or Offtake Agreements.<\/p>\n<p>A rough set of guidelines might be:<\/p>\n<ul>\n<li><strong>1.20x \u2013 1.50x:<\/strong> Lenders might accept these ratios for a simple asset with mostly \u201clocked in\u201d revenue, such as a small solar plant with rates and production governed 100% by a PPA with a nearby utility company. A regulated water utility or PPA-governed onshore wind farm might also fall in this category.<\/li>\n<li><strong>1.50x \u2013 2.00x:<\/strong> This ratio might be used for riskier assets or those with less locked-in revenue (or no locked-in revenue). For example, an offshore wind farm with higher development and operating costs or a private roll road with revenue based on traffic volume and modestly escalated rates might be in this category.<\/li>\n<li><strong>2.00x \u2013 2.50x:<\/strong> Energy assets without <em>any<\/em> locked-in revenue could go here; natural resource assets (e.g., mines and oil &amp; gas fields) might also qualify, even if they have a percentage of locked-in revenue via offtake agreements.<\/li>\n<li><strong>2.50x \u2013 3.50x+:<\/strong> These higher DSCR levels are usually used for much riskier assets, such as mining developments without <em>any<\/em> locked-in revenue that are subject to swings in commodity prices. Lenders need to protect against the risk of lithium or copper prices falling by 50% in one year.<\/li>\n<\/ul>\n<p>The basic idea is simple: <strong>The higher the risk, the higher the DSCR that lenders want to see.<\/strong><\/p>\n<p>Also, note that there is a difference between DSCR <em>targets<\/em> and DSCR <em>covenants<\/em>.<\/p>\n<p>Debt may be sized and sculpted based on the targeted DSCR levels, but if the asset falls below those levels, it\u2019s not necessarily the end of the world.<\/p>\n<p>Lenders might not be happy, but if they receive their scheduled payments, they won\u2019t necessarily impose penalties.<\/p>\n<p>The <em>covenants<\/em> are usually lower than the <em>targets<\/em> and serve more like \u201chard requirements.\u201d<\/p>\n<p>If an asset falls below these minimums, the lenders might impose penalty fees, or, in extreme cases, even seize collateral, as all loans in Project Finance are secured against the specific assets used in the project.<\/p>\n","protected":false},"excerpt":{"rendered":"<p>The Debt Service Coverage Ratio in Project Finance is defined as the Cash Flow Available for Debt Service (CFADS) in One Year \/ Debt Service in One Year, where the Debt Service equals the scheduled Interest + Principal Repayments for that year.<\/p>\n","protected":false},"featured_media":0,"template":"","class_list":["post-29864","biws_kb","type-biws_kb","status-publish","hentry","kb_category-project-finance"],"acf":[],"_links":{"self":[{"href":"https:\/\/breakingintowallstreet.com\/wp-json\/wp\/v2\/biws_kb\/29864","targetHints":{"allow":["GET"]}}],"collection":[{"href":"https:\/\/breakingintowallstreet.com\/wp-json\/wp\/v2\/biws_kb"}],"about":[{"href":"https:\/\/breakingintowallstreet.com\/wp-json\/wp\/v2\/types\/biws_kb"}],"wp:attachment":[{"href":"https:\/\/breakingintowallstreet.com\/wp-json\/wp\/v2\/media?parent=29864"}],"curies":[{"name":"wp","href":"https:\/\/api.w.org\/{rel}","templated":true}]}}