I enjoy teaching ratios and results on my financial modelling courses almost as much as trying to trap participants into making circular references. There are many elements to think about and many things that can go wrong; for example, double counting, timing assumptions, crystal ball gazing, treatment of cash balances and the numerous ways of calculating NPVs.
For infrastructure and energy projects the main banking ratios are the Debt Service Cover Ratios (DSCRs), Interest Cover Ratios (ICRs) and Loan Life Cover Ratios (LLCRs). Of course, the results modelled should be what is negotiated, but some definitions make more sense than others.
Here are three simple checks to see if the cover ratio calculations are logical:
- When Available Cashflow equals Debt Service, are the DSCRs and LLCRs equal to 1.00?
Make Available Cashflow = Debt Service. This means that there is exactly the right amount of cash to service debt and therefore all DSCRs (without any cash balances) and LLCRs should equal 1.00.
If this is not the case, then check the definitions and calculation methods. Surely it is misleading to have exactly the right amount of cash to service debt but cover ratios that do not equal 1.00.
- Is the last LLCR equal to the last DSCR?
The final period LLCR should always equal the final period DSCR.
Why should these be the same? Because:
Final Year LLCR:
= NPV of Available Cashflow Final Period / Debt Balance Final Period
= NPV of Available Cashflow Final Period / NPV of Debt Service Final Period
= Available Cashflow Final Period / Debt Service Final Period
= Final Year DSCR
(Note that in a semi-annual model, the final LLCR should equal the final semi-annual DSCR. However, if rolling annual DSCRs are calculated, the final LLCR will not equal the final ratio).
- Is the first LLCR approximately equal to the average DSCR?
Unless there are substantial differences in the DSCRs over time, the first LLCR (which should be measured only when debt is fully drawn) should be approximately equal to the average DSCR (without any cash balances). If this is not the case, then check the calculation methods.
Why should these ratios be approximately the same? Because:
First LLCR
= NPV of Available Cashflow over the loan life / Debt Balance at the start of Debt Service
= NPV of Available Cashflow over the loan life / NPV of Debt Service
Average DSCR
= average of Available Cashflow / Debt Service
Therefore, the first LLCR is measuring something very similar to the average DSCR, but on a discounted basis. In particular, if all DSCRs are constant, then the first LLCR should always equal the DSCR.
If these three tests are not met, I would suggest that the ratios are giving misleading results. Therefore, perhaps check the definitions. After all, the purpose of the cover ratios is to show how likely it is that the debt service is covered.