What is meant by Debt Service Coverage Ratio | ApnaCourse

by | Nov 10, 2016 | Financial Management

 Manu

Conversation Between

Vinu

 1

 Manu and Vinu about
DSCR (Debt Service Coverage Ratio)

 2
Manu Hi Vinu!
Vinu Hi Manu! I was about to call you! Thank god, you had come!
Manu Regarding?
Vinu I was to understand about one important ratio.

It’s for my friend.

He approached Bank for Long Term Loan for his company.

Manu Ok!
Vinu Bankers were quoting DSCR ratio is too low and hence they cannot support.

My friend is also novice like me!

So only you should help us!

Manu Sure Vinu!

DSCR is acronym of Debt Service Coverage Ratio.

Mainly used by Bankers.

Vinu Ok.

Why bankers calculate this ratio?

 1
Manu Bankers calculate this ratio to know whether the borrower has got repayment capacity to service back the loan with interest.
Vinu Ok! Please tell me how it is calculated.
Manu Sure Vinu!

If you want to repay loan, what is important?

Is it profit or cash?

Vinu Profits!!!
Manu No Vinu!

It may so happen, you report loss, and still you may be able to pay you loans.

Vinu How’s that?
Manu Let say you have high level of depreciation and non-cash expenses in a year. In that year, your

– Expenses will be more

– Profit will be less or even loss.

But, still you would have generated cash from operations.

Vinu Yes! Yes!
Manu So, the focus of the bankers will not be on your Book Profits but will be on Cash Profits.
Vinu Acha!
Manu Cash Profits are also called as Cash Accruals.  2
Vinu Ok. How to calculate this cash accrual?
Manu It’s very simple.

When you take a term loan, what will be your obligations to bankers?

Vinu It will be payment of interest and principal.
Manu Good! So you should identify the cash profits which are available for paying both.
Vinu Ok!
Manu So which profit you will give your cash profits?

PAT?

PBT?

PBIT?

PBDIT?

Vinu Hmmm????

I cannot take PAT because it is after paying interest.

I want to know the profit available for paying interest.

So I should go with Profit Before Interest and Tax (PBIT).

Is that right Manu?

Manu You are partly right, in the sense, you are starting with Profit before Interest. From this profits, you can pay interest. But you have missed one aspect.
Vinu Hmmm…?

Manu, why not we shall have some number to understand?

Manu Ok.

This time I’ll give you the numbers.

Vinu Ok.
Manu
                       Income Statement                                 (Rs. In Cr)
Sales 100
Less: Operating Expenses before Depreciation 50
PBDIT 50
Less:Depreciation 20
PBIT 30
Intrest 10
PBT 20
Tax 06
PAT 14
Vinu Ok! What about Loan repayment?
Manu Ok! Assume Principal repayment as 10 Cr. You already have interest figure in Income Statement.
Vinu Ok.
Manu Now tell me, which profit should be considered as cash profit available for servicing loan obligations?
Vinu It is PBIT of Rs.30.
Manu  3
Vinu Why? It is the profit before Interest and from this portion only, interest is paid and the balance for repaying principal.
Manu No Vinu!

Focus is on Cash Profit.

Not merely profit before Interest.

Vinu Ok! Ok!

I should consider Profit before Depreciation ALSO – right?

i.e., I should consider PBDIT (Profit before Depreciation and Interest) right?

Manu Partly right!
Vinu Again partly?

Where the hell I am missing?

 4
Manu That you can find by yourself.
Vinu How?
Manu Check whether you can pay your interest and principal from PBDIT.
Vinu Ok.

PBDIT – 50

That is my source.

Interest – 10 &

Principal – 10

are my uses.

Manu Stop!

Do you think, entire PBDIT is available for paying interest and loan repayment?

Vinu Yes! Why not?

From PBDIT only interest is paid and we derive PBT.

Manu Yes! I agree. But from PBT you are going to pay tax also!!!!!!!!!!!
Vinu  5 Oooppsss!!!!

I missed the tax component.

I have to pay tax of Rs.6 Cr and it will not be available for paying loan obligations. You are right!

Manu Yes!

So understand, your entire PBDIT is not available for servicing loan. You have to shell out portion of your PBDIT for tax and only the balance will be available for servicing.

Vinu Correct .

So it should be

Profit After Tax 50
Less: TAX 06
Cash Profits 44
Manu Yes! Alternatively you can also arrive Cash Profits (Accruals) in reverse method.

 

Profit After Tax 14
Add: Interest 10
Add: Depreciation and other non-cash items 20
Cash Profits 44

 

Both the approaches gives you the same result.

Vinu True!

So, from this cash profits, we have to divide loan obligations – is that right?

Manu Yes!

DSCR = Cash Accruals / Loan obligations (Principal + Interest)

Vinu Ok!

In our case,

Cash Accruals = 44

Loan obligations (Principal 10 + Interest 10) = 20

DSCR = 44 / 20 = 2.2 Times

Manu Excellent.
Vinu Thank You. What does this ratio communicates?
Manu It tells you, whether you have sufficient profits to pay your loan obligations. (Principal + Interest)
Vinu Is it calculated for every year?
Manu Yes! It is calculated for each and every year of loan period to know whether you can service the loan without any difficulty.
Vinu Ok. What is the ideal DSCR?
Manu Ideal DSCR is 1.75 Times
Vinu What does that mean?
Manu It means you have cash profits 1.75 times of loan obligations.
Vinu Why 1.75 Times is required? Why not mere 1 Time?
Manu Vinu! Understand, you are not going to run your business just to make profits exactly equivalent to your loan obligations.

As an owner you should have some profits – right?

Vinu Yes! Yes! Forgot that!
Manu Apart from that, you need some more profits to support your operations.

Remember you current ratio of 1.33

It means, owners should contribute 25% to the operations of the company.

It will not be possible for the owners to contribute from their pocket every time in the form of capital.

Instead, they can make use of profits for supporting operations.

For that you should have some profits, after paying you term loan obligations.

That’s why, 1.75.

Meaning, after using 1 Time of your resources for paying loans, you will still have 0.75 times of cash profit for your operations.

This will ensure liquidity in operations.

Vinu Correct Manu.

In our case, we had cash profit of 44.

Whereas repayment was only 20.

So after paying 20, we are left with cash profits of 24 which may be used for supporting operations.

Manu True!

For this reason only, Bankers will be insisting on DSCR of 1.75 or more.

It is only in your interest so that you don’t suffer liquidity strain by taking a long term loan.

Vinu Yes Manu!

How good our Bankers are???

 6
Manu Yes! Enjoy two Saturday holidays of Bankers!
Vinu  7
N Raja CA, A Practicing Chartered Accountant with tonnes of passion for teaching. He also holds a PGDBA – Finance from Symbiosis SCDL and a B.Com., from Loyola College, Chennai. Read More.

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