What is meant by Debt Service Coverage Ratio | ApnaCourse
Manu and Vinu about
Manu and Vinu about
|Vinu||Hi Manu! I was about to call you! Thank god, you had come!|
|Vinu||I was to understand about one important ratio.
It’s for my friend.
He approached Bank for Long Term Loan for his company.
|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!
DSCR is acronym of Debt Service Coverage Ratio.
Mainly used by Bankers.
Why bankers calculate this ratio?
|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.|
If you want to repay loan, what is important?
Is it profit or cash?
It may so happen, you report loss, and still you may be able to pay you loans.
|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.
|Manu||So, the focus of the bankers will not be on your Book Profits but will be on Cash Profits.|
|Manu||Cash Profits are also called as Cash Accruals.|
|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.|
|Manu||So which profit you will give your cash profits?
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.|
Manu, why not we shall have some number to understand?
This time I’ll give you the numbers.
|Vinu||Ok! What about Loan repayment?|
|Manu||Ok! Assume Principal repayment as 10 Cr. You already have interest figure in Income Statement.|
|Manu||Now tell me, which profit should be considered as cash profit available for servicing loan obligations?|
|Vinu||It is PBIT of Rs.30.|
|Vinu||Why? It is the profit before Interest and from this portion only, interest is paid and the balance for repaying principal.|
Focus is on Cash Profit.
Not merely profit before Interest.
I should consider Profit before Depreciation ALSO – right?
i.e., I should consider PBDIT (Profit before Depreciation and Interest) right?
Where the hell I am missing?
|Manu||That you can find by yourself.|
|Manu||Check whether you can pay your interest and principal from PBDIT.|
PBDIT – 50
That is my source.
Interest – 10 &
Principal – 10
are my uses.
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!!!!!!!!!!!|
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!
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.
So it should be
|Manu||Yes! Alternatively you can also arrive Cash Profits (Accruals) in reverse method.
Both the approaches gives you the same result.
So, from this cash profits, we have to divide loan obligations – is that right?
DSCR = Cash Accruals / Loan obligations (Principal + Interest)
In our case,
Cash Accruals = 44
Loan obligations (Principal 10 + Interest 10) = 20
DSCR = 44 / 20 = 2.2 Times
|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.
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.
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.
How good our Bankers are???
|Manu||Yes! Enjoy two Saturday holidays of Bankers!|