Learn about DSCR through conversation between Manu & Vinu followed by video lecture

MANU			VINU
Manu	Hi Vinu!
Vinu	Hi Manu! I was about to call you! Thank god, you had come!
Manu	Regarding?
Vinu	I want 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?
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.
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 Interest 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	No
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?
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	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 PBDIT 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???
Manu	Yes! Enjoy two Saturday holidays of Bankers!
Vinu

To know more about DSCR, watch this video lecture:

Note: This video is part of my Online Course

BANKING CREDIT ANALYSIS PROCESS
https://www.instamojo.com/caraja/banking-credit-analysis-process/