Debt service coverage ratio (DSCR) is a very important ratio used extensively by lenders to check if the borrower company has sufficient cash flow to pay the installment of the debt. Many times, the decision for extending term loan depends on this ratio.
A company in need of long-term loan prepares projections for future periods to assess the viability of the project. The lenders are interested in the period for which they are extending a loan. For example, a term loan is to be sanctioned for 10 years. The DSCR for each of these 10 years will be calculated and all of them should be more than ‘1’ at least.
HOW TO ANALYZE / INTERPRET THE DEBT SERVICE COVERAGE RATIO (DSCR)?
For a particular financial year, the result of DSCR is an absolute number. This number has different implications if it is below or above ‘1’.
DSCR below ‘1’
First, let us understand why DSCR will be below ‘1’. It is simply because numerator (Operating Income) is less than the denominator (installment and rentals). It can be interpreted as insufficient cash availability against the requirement. A lender is only interested in repayment of principal and interest of the proposed loan. Here, when DSCR is less than ‘1’, the borrower will not be able to pay that. This is why it is not a desirable situation. Reasons for DSCR below ‘1’ could be that the business idea is not feasible and it is not possible to make the profit out of it.
Another reason could be the term of the loan. If the term of a loan is too small, the installment amount would be big and that can drive DSCR down. Considering the viability and business model of the company, the lenders can make changes in the schedule of payment. It can increase the term of the loan or can give ballooning effect to the installments. Adjusted DSCR is used when such kind of situations persists.
DSCR above ‘1’
Let us understand when a DSCR will be above‘1’. The logic is same if the numerator (net cash accruals) is more than the denominator (installment and rentals). It can be interpreted that the borrower has sufficient cash availability to pay to the lenders (installments and interest thereon). In this case, the lender will lend the money because the possibility of repayment is there. Now, we can say the situation of ‘DSCR above 1’ is better than ‘DSCR below 1’. Still we are not clear what should be the ideal situation. Let us try understanding that.
Generally speaking, higher the ratio better it is. Still we need some benchmark to decide. Below that benchmark, it is not acceptable, and above that, it is acceptable. Mostly DSCR between ‘1.25 to 2’ is considered good and satisfactory. Why we need DSCR of more than ‘1’, because it is calculated based on the projections. There is always a risk of projections not turning correct. There may be abnormal periods in between. This calls for a margin of safety. It is understood that anything above ‘1’ increases the possibility of payment by the borrower. Norms for ideal DSCR may vary with different countries, different types of loans, different industries etc.
Too High DSCR
Do we mean DSCR of more than 2.5, 3, 4 etc is too good. What does it mean? Too high a DSCR means the company can borrow more money but it is not borrowing. In other words, the potential benefit of leverage due to debt proportion in the capital structure is not taken. Higher debt in the capital structure brings down the overall cost of capital because debt is the cheaper source of capital for a business.
HOW TO IMPROVE THE DEBT SERVICE COVERAGE RATIO (DSCR)?
Negotiate Raw Material Prices
Any reduction in expenses can increase the profit after tax and thereby give an increasing effect to DSCR. The expenses can be reduced by negotiating and revising the contracts with suppliers of materials, consumables, etc.
Revisiting the Vendor Selection
By a tender system of vendor selection, the quotation by various vendors can be compared and the vendor with best prices and acceptable quality can be appointed. Once the purchase process is improved, the efficiency and cost saving due to this would be reflected in the PAT and that in turn will improve the DSCR.
An Increase in revenue can help in improving the PAT and thereby DSCR. The increase in revenue can be achieved with two things – increase the quantity of sale or increase the price of the product. The quantity increase can be achieved with increased orders, marketing, advertisement, etc. A Higher price can be achieved by either differentiation of the product or better quality of the product.
Increase Term of Loan
Increasing the term of a loan would decrease the installment amount of each year. That will reduce the denominator and thereby increase the DSCR.
Reduce the Rate of Interest
The amount of interest is a part of the denominator of the DSCR formula and if the rate of interest is reduced to some extent, the interest amount will reduce and that would result in a decrease in the installment amount. That would decrease the denominator and hence would improve the DSCR.
It is a common situation for all new businesses that the cash flow in the initial periods is low due to lower capacity utilization. Adjusting the installment with the fashion of cash flow i.e. keeping lower installments for first few years and then increasing them is called ballooning effect. This makes the DSCR comfortable for both initial years as well as later years. Otherwise, the DSCR would be too low in the initial period and too high in the later periods.Last updated on : July 5th, 2017