DSCR - Much more than an indicator - Pt. 1

The DSCR, acronym for Debt Service Coverage Ratio , is a forward-looking financial indicator used in modern financial analysis to measure the real repayment capacity of the company.

This informative capacity gives it a certain ambivalence, as it can be used:

• both from a banking perspective, to verify the sustainability of debt, as an IFRS 9 compliant indicator (due to the high informative value that is recognized in it, banks in recent years have increasingly integrated it into their evaluation models, tying it mainly to the granting of medium-term financing);
• both from a corporate perspective, to help management better understand the company's financial dynamics, in a forward-looking , i.e. forecasting, perspective.

Born in the 90s in the world of Project Financing as a measure to evaluate the financial sustainability of an investment project - together with other indicators that later turned out to be of secondary importance such as LLCR and PLCR - in recent years its popularity has grown dramatically, as recent economic crises have shifted attention to the company's ability to generate financial resources . This is because even if the company has significant assets and assets, but these are difficult to transform into liquidity (for example real estate), this does not necessarily mean that it is solvent and able to properly meet the financial commitments made to credit institutions.

In addition, the reform of bankruptcy law, with the repeated application of the new Code of Corporate Crisis and Insolvency, had initially placed emphasis on this indicator, codified in the document of the National Council of Chartered Accountants and Accounting Experts of 20 October 2019, and considered capable of intercepting corporate crises early.

The DSCR is a financial index , therefore it puts two financial quantities, i.e. two flows, in relation to each other, and is not limited to quantifying in a "static" manner, for example the total amount of financial debt in relation to net equity, but analyses in a dynamic and prospective way the company's debt repayment capacity, also and above all considering the company's development plans .

The calculation methods of the DSCR are not at all univocal: as for almost all balance sheet indices, there are different approaches and calculation methods.

The construction of this indicator, apparently a trivial ratio, is decidedly more sophisticated than other well-known and widely used indices, so its calculation has various declinations depending on who calculates it or the purpose for which it is calculated.

For example, the banking approach currently tends to adopt a so-called “simplified” method to calculate the DSCR, and this is due to obvious needs in having to manage large amounts of operations.

Beyond the various formulas, which we will see later, the DSCR in its classic formulation is calculated as a ratio between an operating cash flow and the total amount of the expected debt repayment , both in capital and interest , in addition to commissions and other charges related to the financing itself, so:

• in the NUMERATOR there will be a cash flow from ordinary activities available to pay the installments;
• The DENOMINATOR will contain all the capital, interest and other financial charges that we will have to repay.

It is easy to understand how it is strictly necessary that the numerator is greater than the denominator, therefore that the DSCR is greater than 1.

More precisely:

• a DSCR greater than 1 means that the company will generate abundant cash flows compared to the expected repayments; consequently, the company demonstrates the ability to meet its commitments towards financial creditors;
• A DSCR lower than 1 means that the company produces cash flows of an amount lower than the expected repayments; in this case the company highlights situations of financial stress and probable difficulty in repaying its debts.

This is true, but only abstractly. In fact, since the calculation is based on prospective and therefore estimated data, it is believed that a ratio equal to one is not sufficient by itself to guarantee the lender the financial stability of the financing operation, but an adequate safety cushion is necessary.

This is why in the banking world:

• to grant new debt, credit institutions normally require that this indicator be at least equal to 1.10–1.25 ;
• for values ​​between 1.00–1.10 and the outcome is not always a given, and it becomes essential to carry out further investigations into the company, which will be subjected to careful scrutiny (much depends on the indicator's 1–2 year forecasts, the destination of the sums requested and the guarantees offered);
• below the value of 1.00 the operation is perceived as very risky, therefore the financing request will most likely not be accepted.

In the second part of the article, some of the main methods of calculating the DSCR will be analyzed, with particular reference to the banking world.