DSCR - Much more than an indicator - Pt. 2

In the first part of this contribution we saw the general principles underlying the construction of the DSCR, in its basic formulation which sees it as a relationship between financial flows .

Let's now look at the various methods of calculating the DSCR, methods that manifest themselves within these two worlds:

• the world of BANKS;
• the world of the CRISIS CODE.

As is known, following the economic crises that began towards the end of the first decade of the 2000s, banks have radically changed their process for evaluating potential clients, due to the ever-increasing pressure from the European Central Bank (ECB) and the European Banking Authority (EBA).

In fact, in collaboration with the national supervisory authorities, controls on banks have been increased, which are now subjected to in-depth assessments in order to analyse their financial health and resistance to possible macroeconomic and/or financial shocks (unfortunately now increasingly frequent).

These assessments are based on two distinct phases:

• an Asset Quality Review , aimed at increasing the transparency of institutions on their exposures, the adequacy of their activities and the related provisions to cover risks;
• a stress test , or a scenario analysis, in which the profitability and, more generally, the stability of the bank is monitored following a hypothetical shock to the economy.

The main credit institutions, following these measures, have progressively aligned themselves with the community provisions, starting to adopt internally evaluation models, with regard to their own balance sheet data and those of their client companies. In particular, the second evaluation phase, that is, the one focused on the effects of probable economic shocks, has highlighted the importance for banks to constantly monitor some key indicators , in order to try to predict the greater / lesser resistance of the company to a macroeconomic shock.

These indicators, obtained from company balance sheet data or from the Central Risk system, are now widely adopted by financial institutions, due to their immediacy and accuracy in predicting the financial sustainability of the company in a given time horizon.

The most widespread formula in the banking world is also the simplest and most immediate, and is the following:

The great simplification highlighted by the formula consists in using in the numerator not a flow as the original formulation of the DSCR would have it, but an economic quantity: the EBITDA. This is because the EBITDA, being an income margin that measures the operating profit before amortization and depreciation (which are non-monetary costs), interest, extraordinary components and taxes, is considered a proxy of the operating cash flow. This greatly simplifies the work of the credit institution, which in this way is able to calculate the DSCR with easily available data; for an evaluator external to the company, in fact, it may not be easy to identify the financial flows, especially if this operation must be repeated on a large number of client companies.

A slightly more elaborate formulation is the following, in which the cash flow roughly estimated from EBITDA is refined by also considering the effect of both changes in Net Working Capital and the cash outflow due to taxes:

A further variant of the traditional formula for calculating the DSCR takes into account, in addition to installment debts towards banks, also tax and/or social security debts that are overdue and/or in installments, the payment date of which falls within the time horizon considered in calculating the indicator. Such a calculation methodology is especially useful when the bank is faced with companies with significant tax or social security debts that have not been paid by the due dates.

In this case the formula becomes:

We have already seen previously how the value assumed by the DSCR should always be higher than the minimum threshold of 1.10, although to be considered optimal it should exceed the threshold of 1.25.

In the light of the aforementioned Asset Quality Review, a fall in the index below the threshold of 1.10 will give rise to an impairment trigger , with the consequent reclassification of the debtor, which would be downgraded from performing loan to underperforming loan or even non-performing loan , with the consequence that the bank would have to make significantly higher provisions to cover any future losses.

For completeness, the following formula is presented, proposed by authoritative doctrine as the most complete and reliable formula for calculating the DSCR:

The advantage of this formula, which is not so widespread, lies in further refining the calculation of flows by eliminating the distorting effects of leasing , due to its accounting with the so-called "equity" method, which forces the accounting operators of non-IAS companies to consider it as a cost and not as a debt , as the nature of the operation itself would require.

By calculating the DSCR in this way, the numerator increases because the EBITDA is adjusted for the leasing fees contained in it (i.e. the costs for leasing fees are added); at the same time, the denominator also increases to take into account the financial outflows due to leasing: the result is a DSCR that is certainly more truthful and reliable .

The third part of the article will analyze the methods of calculating the DSCR in relation to the CNDCEC approach in the context of business crisis.