Monday, July 9, 2018

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/

 click here


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