Debt Coverage Ratio (DCR)

Unlike corporate finance, in project finance lenders are paid back solely through the cash flows generated by the project (CFADS) and DCR functions as a barometer of health of those cash-flows. It measures, in a given quarter or 6-month period, the number of times that the CFADS pays the debt service (principal + interest) in that period.

The debt service ratio (DSR) formula is as follows.

Where:

• Debt Service = Principal + Interest

Project Finance Debt Coverage Ratio Calculation Example

The debt coverage ratio (DCR) is calculated as CFADS divided by debt service, where debt service is the principal and interest payments due to project lenders. For example, if a project generates $10 million in CFADS and debt service for the same period is $8 million, the DCR is $10 million / $8 million =  1.25x.

What is the Role of Debt Coverage Ratio in Project Finance?

The debt coverage ratio (DCR) is used for two main purposes in project finance:

1. Sculpting and Debt Sizing
2. Covenant Testing

1. Sculpting and Debt Sizing

This is used prior to financial close, in order to determine the debt size, and the principal repayment schedule.

Lenders will set debt sizing parameters, typically including a gearing (or leverage) ratio (Loan to Cost Ratio) and a DCR (sometimes a LLCR in addition to, or instead of, a DCR). While the gearing ratio helps to ensure that equity has skin in the game, the DCR target ratio helps to ensure that a minimum DCR is maintained at all times.

Here the formula is rearranged, and the debt service is calculated based off the forecast CFADS and specified DCR.

The debt service can be thus calculated in every period to satisfy the lenders sizing parameters. Sculpting the debt service based off the CFADS and target debt service will yield a debt service profile that follows the CFADS (as above).

Upon adding all the principal components of the debt service up, that will calculate the debt size. Learn more about debt sizing here and learn to build macros to automate the process here.

2. Covenant Testing

As the loan is getting repaid during the operations phase of a project, covenants are set in terms of maintaining minimum DCRs. There are two covenants to pay attention to

• Lock-up: DCRs form a part of the lock-up covenants. For example, if cash-flows breach a minimum covenant of 1.10x, this may trigger a project lock-up. There are different restrictions that this may trigger, but the main one is a restriction of distributions to equity holders.
• Default: If the DCR is less than 1.00x, that means that the project cashflows are not sufficient to meet the projects debt service obligations. Per the facility agreement, this would constitute a project default, which means that the lender has step in rights; and can run the project in their best interests.

The function of these covenants is to give lenders some control, providing a mechanism through which to bring the project sponsors to the table to re-negotiate.

In Period vs. Annual Ratio: What’s the Difference?

The DCR can be expressed as both an “in-period” or an annual ratio. The project term sheet will specify how covenants are calculated. As it can fluctuate from period to period, covenants may be defined annually via a LTM (last twelve months) or NTM (next twelve months) summation.

Minimum vs. Average Debt Coverage Ratio (DCR): Difference?

The minimum DCR is usually pulled out of the model to be presented on summaries – this helps to identify a period of weak cashflows and when it occurs.

The average DCR is a useful overall metric to understand how many times the total CFADS during the debt tenor covers the debt service. While a useful metric to have, it is less sophisticated than the LLCR, which takes into account the timing of cashflows through discounting

Debt Coverage Ratio (DCR) Volatility in Cash-Flows

If the future was perfectly known and the CFADS forecast exactly equaled the CFADS generated, then the debt service could theoretically be set at exactly equal to the CFADS (in other words, the DCR could be 1.00x).

That’s because the lender would be certain to be paid back in every quarter.

Of course, this is theoretical and wouldn’t be favorable to equity investors, who are incented to get distributions as soon as possible (with a cost of equity higher than the cost of debt).

The greater the uncertainty in cash-flows (CFADS), the higher, the buffer between CFADS and debt service. Thus, the riskier the project, the higher the DCR.

What is a Good Debt Coverage Ratio (DCR) By Industry?

The below DCRs are indicative only, as each project will vary. Different industries have different risk profiles, and thus different DCRs.

• Projects with Low DCR: Projects that have no demand risk will have a low DCR, like an availability based toll road (i.e. the SPV is paid based on having the road available and meeting certain conditions, rather than the level of traffic).  Another example might be a regulated water utility, which due to stable incomes will have a low DCR.
• Projects with High DCR: A power generator, on the other hand, is exposed to fluctuations of electricity prices. Throw in no counterparty with a contracted requirement to take the power, and the project is truly at the mercy of the markets. As a result, the project would carry a higher DCR.