Debt Service Coverage Ratio: Two Views Are Better Than One

[Pages:9]Credit Risk

Debt Service Coverage Ratio

Two Views Are Better Than

One ??A case study compares

two methods for calculating and analyzing debt service coverage ratios.

by John T. Grady

Financial analysis is the cornerstone of credit risk assessment. Commercial lenders and analysts study financial statements and perform ratio analysis to identify and understand the risks in lending to a business. The business's debt service coverage ratio (DSCR) is one of the key ratios to calculate and analyze as a measure of the borrower's ability to repay debt. Bankers place heavy reliance on the DSCR when making credit decisions.

The DSCR measure used by many bankers is the traditional debt service coverage ratio (TDSCR). The TDSCR is a simple and straightforward way to measure and evaluate a borrower's ability to service debt. TDSCR is calculated using a handful of numbers from the business's income statement and balance sheet. A second, more detailed method to calculate DSCR is to use the information reported in the borrower's UCA cash flow statement (UCACFS). The purpose of this article is to apply these two methods for calculating DSCR. It also will highlight the differences between the two DSCR calculations and show the added benefit that the UCA-based calculation can bring to the credit analysis.

Let's look at a case study--Classic Candies LLC., a family-owned manufacturer and distributor of chocolate candies that has been in business since 1975. Its leading products are coconut- and cr?me-filled chocolate eggs and chocolate novelties. Historically, its primary customers have been retail chocolate shops, gift shops, and gourmet

markets. After several years of sluggish sales from 2002 to 2005, Classic aggressively pursued new business, including introducing its Brown Bear fund-raising line of chocolates. Initially, the fund-raising market proved to be very lucrative, and sales increased significantly from 2005 to 2007. With the downturn in the economy during the second half of 2007 and into 2008, however, Classic's Brown Bear sales slowed. In addition, collections of Brown Bear receivables from fund-raising organizations also slowed. In light of strained earnings and cash flow, in July 2008, Classic revaluated its marketing strategy and chose to stop selling to certain fund-raising customers. Although sales and net income dropped, cash flow improved as receivables turnover improved and inventory was reduced. Classic is satisfied with the results and feels that the company is well-positioned for the future.

Classic operates in one main location that contains manufacturing, warehousing, and office space. In 2006, the company spent $500,000 to upgrade its molding machines and assembly lines and purchase new packaging equipment for the Brown Bear product line. Use of the equipment continues, although not at the level originally planned. Classic expects sales to increase as the economy recovers, however, with a corresponding increase in plant utilization. As the business has grown, Classic has used line of credit borrowings to meet its working capital needs.

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April 2010 The RMA Journal

Classic has a line of credit with a local bank that increased steadily from $1.5 million in 2004 to $3 million in 2008 to keep up with growth. During 2008, Classic was able to significantly pay down the line as it reduced its accounts receivable and inventory. The line is collateralized by a blanket lien on business assets and has no borrowing base or advance formula. Classic also has a mortgage and equipment financing with the bank.

Here are Classic's income statement and balance sheet for 2005?08:

Table 1 Sales/Revenues

Income Statement

Classic Candies, LLC--Income Statement

12/31/2005 12/31/2006 12/31/2007

19,847

22,824

25,106

12/31/2008 22,581

Cost of Sales/Revenues Gross Profit

14,397 5,450

16,931 5,893

18,624 6,482

16,761 5,820

Selling Expense General & Admin Expense Officers' Compensation Depreciation Personnel Expense Other Operating Expense Total Operating Expense Net Operating Profit

789 325 1,600 211 717 924 4,566 844

920 400 1,780 265 878 1,379 5,622 271

1,250 375

1,600 295 969

1,411 5,900

582

1,125 300

1,400 395 896

1,205 5,321

499

Interest Expense (?) Profit Before Taxes

243

290

641

(19)

275

260

307

239

Current Income Tax Net Profit

86

12

55

85

555

(31)

252

154

Income statement highlights: 1. Sales increased from 2005 to 2007 due to the introduc-

tion of the Brown Bear fund-raising product line. Sales dropped in 2008 due to the dropping of certain slowpaying customers. 2. Steady gross margin: Historically, Classic has strong control over its manufacturing process and costs. 3. Varying operating margin and net income: Advertising and distribution costs increased significantly with the introduction of the Brown Bear line in 2005. With the elimination of certain underperforming fund-raising customers in 2008, Classic has been able to reduce SG&A and payroll. Additionally, in 2008 Classic wrote off $100,000 of intangibles related primarily to the Brown Bear product line. 4. Officers' compensation: In light of the tight economy and retraction of sales in 2008, Classic's officers reduced their compensation by $200,000 (12.5%).

Table 2

Current Assets Cash at TD Accts/Notes Rec-Trade Inventory Prepaids/Deferreds ? CP Total Current Assets Noncurrent Assets Land Building & Improvements Machinery & Equipment Gross Fixed Assets Accumulated Deprec (?) Total Fixed Assets ? Net Intangibles ? Other Total Noncurrent Assets Total Assets Current Liabilities ST Loans Payable-Bank CPLTD-Bank Accounts Payable-Trade Other Accruals Income Taxes Payable Total Current Liabilities Noncurrent Liabilities Long Term Debt-Bank Long Term Debt-Other Other Liabilities-Gray Area Total Noncurrent Liabilities Total Liabilities Net Worth Common Stock Paid-In Capital Retained Earnings Total Net Worth Total Liabilities & Net Worth

Balance Sheet Classic Candies, LLC--Balance Sheet

12/31/2005 12/31/2006 12/31/2007

210

180

180

3,089

3,288

4,439

1,631

1,806

1,780

104

112

128

5,034

5,386

6,527

850

850

850

1,250

1,250

1,250

810

1,350

1,450

2,910

3,450

3,550

1,032

1,297

1,577

1,878

2,153

1,973

230

230

230

2,108

2,383

2,203

7,142

7,769

8,730

1,667

2,048

2,890

245

306

316

1,414

1,482

1,615

135

149

178

41

46

80

3,502

4,031

5,079

1,500

1,380

1,195

570

900

805

35

29

45

2,105

2,309

2,045

5,607

6,340

7,124

3

3

3

297

297

297

1,235

1,129

1,306

1,535

1,429

1,606

7,142

7,769

8,730

12/31/2008

335 3,907 1,450

110 5,802

850 1,250 1,450 3,550 1,897 1,653

130 1,783 7,585

2,120 316

1,510 160 95

4,201

949 735 40 1,724 5,925

3 297 1,306 1,660 7,585

Balance sheet highlights: 1. Assets and liabilities in general increased from 2005

to 2007. In 2008, receivables and inventory decreased with the termination of sales to slow-paying customers. Working capital accounts increased and subsequently decreased, most significantly: ? Accounts receivable. ? Inventory.

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53

? Notes payable (line of credit borrowings). ? Accounts payable. 2. Fixed assets increased as the manufacturing capacity was

expanded and upgraded in 2006. These improvements were largely financed by long-term bank debt. 3. Intangibles decreased by $100,000 during 2008 due to the write-off of certain capitalized costs of the Brown Bear product line.

Debt Service Coverage Ratio

DSCR is a measure of a business's ability to service its debt.

Typically, DSCR is calculated on an annual fiscal statement-

With the widespread

date basis. However, it can be useful to calcu-

weakening of the economy late DSCR on an interim

basis or on a rolling,

beginning in 2007, many four-quarter basis. In

banks have increased the minimum required DSCR from 1.2x to 1.3x.

addition to calculating, analyzing, and evaluating DSCR on a historical basis, a prudent

underwriter will do pro

forma DSCR calculations to estimate the borrower's ability

to service long-term debt in the future (particularly when

new borrowings are involved).

The basic DSCR calculation is:

DSCR = Cash or adjusted net income available to service debt/Debt service

The DSCR calculation denominator is defined as all interest expense and the current portion of long-term debt. The numerator can be either cash available or adjusted net income (ANI) available to service debt. The ANI/debt service calculation is relatively simple, whereas the cash-based calculation usually takes a few more minutes to complete. DSCRs can vary significantly, depending on the method used. The focus of this article is on DSCR from these two perspectives.

Traditional Debt Service Coverage Ratio The TDSCR calculation is an income-statement-driven measure of the borrower's ability to service debt. TDSCR uses adjusted net income as the numerator and is calculated as follows: Adjusted Net Income Available to Service Debt Net income + Noncash expenses or ? Noncash income + Interest expense ? Dividends/distributions = Adjusted net income available to service debt

Debt Service Current maturities of long-term debt + Interest expense = Debt service

Let's take a detailed look at the TDSCR calculation.

Adjusted Net Income Available to Service Debt (Numerator) 1. Net income: Start with the borrower's accrual basis net

income. 2. Noncash expense: Add back noncash expenses (depre-

ciation and amortization expense) since these expenses do not use cash. If the borrower has noncash income, the amounts should be subtracted at this point in the calculation. 3. Interest expense: Add back interest expense. Interest expense is factored in as part of the business's debt service in the denominator of the DSCR calculation. 4. Dividends: Dividends (and distributions to owners) are not an expense included in the calculation of net income. However, they are a use of cash. Certain commercial bankers view dividends/distributions as a discretionary cash outflow and therefore do not account for them in the DSCR calculation. For this article, the dividends will be subtracted to calculate cash flow available to service debt. 5. Adjusted net income available to service debt: The sum of items 1 through 4.

Debt Service (Denominator) 1. Current maturities of long-term debt: CMLTD is the sole

balance sheet number used in the TDSCR calculation. Current maturies represent 12 months of required principal payments on the business's long-term debt. 2. Interest expense: Total interest expense for the business. 3. Debt service: The sum of 1 and 2.

Divide the ANI by the debt service to get the TDSCR. The result tells the lender how the business's ANI covers its required debt payments. A TDSCR of 1.0x indicates that for every dollar of debt payments, the business is generating one dollar of ANI. Historically, commercial lenders have looked for a minimum DSCR of 1.2x. With the widespread weakening of the economy that began in 2007, many banks have increased the minimum required DSCR from 1.2x to 1.3x. A ratio of 1.3x indicates that for each dollar of debt service, the business in generating $1.30 of ANI to service debt, indicating that the company has a cushion of .3x. This cushion is important since the TDSCR is usually used to evaluate future debt-service ability. Having a cushion implies that ANI generated by the business can decrease by 20?30% and still be sufficient to service debt. If the business's TDSCR is 1.0x, any further decrease in ANI will result in insufficient ANI to service debt.

At this point, you may be wondering why I am referring to adjusted net income available to service debt rather than cash available to service debt. This will be explained later in this article.

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April 2010 The RMA Journal

What is Classic Candies' TDSCR? Let's find out. Here is Classic Candies' TDSCR for 2005?08.

Traditional DSCR

2005

Net Income

555

+ Depreciation

211

+ Interest Expense

243

? Dividends

(75)

Adjusted Net Income Available to Service Debt

934

Debt Service

+ CMLTD

245

+ Interest Expense

243

Debt Service

488

Cash Surplus (Deficit)

446

Traditional DSCR

1.92x

2006

2007

2008

(31)

252

154

265

295

395

290

275

260

(75)

(75)

(100)

449

747

709

306

316

316

290

275

260

598

591

576

(147)

156

133

.76x

1.26x

1.23x

What can you infer from the above calculations for Classic Candies? Before reading further, formulate your thoughts and then compare them to the analysis below.

For 2005, the TDSCR indicates that Classic Candies generated more than sufficient ANI to service its debt--for every $1 of debt service, Classic Candies generated $1.92 of ANI. In 2006, Classic Candies' profits took a big hit due to incremental expenses to grow Brown Bear sales, lower profit margin on Brown Bear bars, and increased officers' compensation. As a result, TDSCR for 2006 dropped to .76x, indicating that for every $1 of debt service, Classic Candies generated only .$76 of ANI. Classic's profits and TDSCR rebounded in 2007 to 1.26x, even in the face of a weakening economy. In 2008, although net income decreased by $100, the DSCR of 1.23x is in line with 2007's 1.26x. Can you determine why? Take a minute and review the calculations and related balance sheet and income statement.

Did you recall that in 2008, Classic wrote down Brown Bear bar intangibles by $100? The $100 is included in the depreciation expense line on the income statement. Since the write-off is a noncash expense, it has no impact on ANI, so we add it back along with the remaining depreciation expense to calculate ANI.

Across the years presented, Classic's ANI has been adequate to service its debt for three of the four years. After the down year in 2006, TDSCR has rebounded to a respectable level.

Many commercial bankers are satisfied with calculating and analyzing TDSCR calculations to make their credit decisions. However, I strongly recommend that credit underwriting include a look at the borrower's DSCR from a second perspective--Uniform Credit Analysis cash flow statement (UCACFS). Here's why:

1. Changes in balance sheet accounts: The TDSCR takes into account only one balance sheet account--current maturities of long-term debt. The UCACFS calculation incorporates all balance sheet accounts and therefore gives us much more insight into the cash flow of the business and its ability to service its debts.

2. True "cash" basis calculation: The TDSCR calculation uses "net income" as its starting point. For the vast majority of borrowers, net income is calculated and reported using the accrual basis of accounting. Unless the borrower uses the cash basis of accounting or the stars align perfectly, net income calculated on the accrual basis is not the same as cash income (or cash available to service debt). If you doubt this point, look at any set of financial spreads and compare net income reported on the income statement with net cash income on the UCA cash flow statement. The two amounts will rarely, if ever, be equal. Therefore, when looking at the traditional DSCR calculation, I do not use the term cash available to service debt. Instead, I use the term adjusted net income (ANI) or ANI available to service debt. Let's now look at a cash-based debt service coverage

ratio. The ratio we will examine uses the borrower's UCA cash flow statement as its starting point.

UCA Cash Flow Statement DSCR

To examine a UCA cash flow statement-based DSCR, let's

start with a quick review. The UCACFS looks at cash flow

in three pieces:

1. Cash from operations/net cash income/cash after debt

amortization: The operating section of the UCA cash flow

statement is basically a cash-basis income statement. This

calculation starts with income statement line items and

adjusts each for changes in the respective balance sheet

accounts (sales per the income statement are adjusted for

the change in accounts receivable). Using this method,

net cash from opera-

tions is calculated. The UCACFS calculation

Interest expense is then subtracted to

incorporates all balance

arrive at net cash sheet accounts and

income. The final therefore gives us

step is to subtract

current maturities much more insight into

of long-term debt to arrive at cash after debt amortization. 2. Investing activities/

the cash flow of the business and its ability to service its debts.

capital expenditures:

The second section of the UCACFS reports capital expen-

ditures (Capex) and investing activities. Basically, it's the

year-to-year change in gross fixed assets and investments.

Intangible expenditures are also included in this section.

The RMA Journal April 2010

55

The subtotal of this section (cash paid for plant and investments) is compared to cash after debt amortization, and the resulting post-Capex financing surplus (requirement) is calculated. 3. Financing activities: The third and final section of the UCACFS is the financing section. This section reflects the changes in short-term debt, long-term debt, and capital accounts and includes dividends paid. The sum of the activity in this section totals to the bottom line labeled total external financing. The total external financing is then compared to the financing surplus (requirement) from Section 2 with the difference being the net change in cash (cash after financing) for the year. Here are Classic Candies' UCA Cash Flow Statements for 2005?08:

Table 3 UCA Cash Flow

Classic Candies, LLC--UCA Cash Flow

12/31/2005 12/31/2006 12/31/2007

Sales/Revenues

19,847

22,824

25,106

Chg in Accts/Notes Rec-Trade

(727)

(199)

(1,151)

Cash Collected from Sales

19,120

22,625

23,955

12/31/2008 22,581 532 23,113

Cost of Sales/Revenues Chg in Other Inventory Chg in Accounts Payable-Trade Cash Paid to Suppliers Cash from Trading Activities

(14,397) (417) 200

(14,614) 4,506

(16,931) (175) 68

(17,038) 5,587

(18,624) 26

133 (18,465)

5,490

(16,761) 330

(105) (16,536)

6,577

Selling Expense General & Admin Expense Officers' Compensation Personnel Expense Other Operating Expense Chg in Prepaids/Deferreds ? CP Chg in Other Accruals Cash Paid for Operating Costs Cash After Operations

(789) (325) (1,600) (717) (924)

(9) 19 (4,345) 161

(920) (400) (1,780) (878) (1,379)

(8) 14 (5,351) 236

(1,250) (375)

(1,600) (969)

(1,411) (16) 29

(5,592) (102)

(1,125) (300)

(1,400) (896)

(1,205) 18

(18) (4,926)

1,651

Current Income Tax

(86)

Chg in Income Taxes Payable

6

Other Income (Exp) & Taxes Paid

(80)

Net Cash After Operations

81

(12)

(55)

(85)

5

34

15

(7)

(21)

(70)

229

(123)

1,581

Calculating the UCA Cash Flow Statement Debt Service Coverage Ratio (UCA DSCR) Looking at Classic's UCA cash flow statements, what section and line items are similar to the traditional ANI DSCR calculation? Take a minute to examine the UCA cash flow statements. If you said that the bottom lines of Section 1 of the UCA statements, net cash from operations, net cash

Table 3 Classic Candies UCA Cash Flow Statements for 2005?2008 (continued)

Classic Candies, LLC--UCA Cash Flow

12/31/2005 12/31/2006 12/31/2007 12/31/2008

Interest Expense (-)

(243)

(290)

(275)

(260)

Cash Paid for Dividends & Interest

(243)

(290)

(275)

(260)

Net Cash Income

(162)

(61)

(398)

1,321

CPLTD-Bank

(230)

(245)

(306)

(316)

Current Portion Long Term Debt

(230)

(245)

(306)

(316)

Cash After Debt Amort.

(392)

(306)

(704)

1,005

Chg in Machinery & Equipment

-

(540)

(100)

-

Chg in Accumulated Deprec (-)

211

265

280

320

Depreciation

(211)

(265)

(295)

(395)

Chg in Net Fixed Assets

-

(540)

(115)

(75)

Chg in Intangibles ? Other

(30)

-

-

100

Chg in Net Intangibles

(30)

-

-

100

Cash Paid for Plant and Investments

(30)

(540)

(115)

25

Financing Surplus (Requirements) (422)

(846)

(819)

1,030

Chg in ST Loans Payable-Bank

417

381

842

(770)

Chg in Long Term Debt

15

516

36

-

Chg in Other Liabilites-Gray Area

5

(6)

16

(5)

Dividends ? Stock

(75)

(75)

(75)

(100)

Total External Financing

362

816

819

(875)

Cash After Financing

(60)

(30)

-

155

Add: Cash at TD Ending Cash & Equivalents

270

210

180

180

210

180

180

335

income, and cash after debt amortization are similar to the traditional ANI DSCR calcuation, you are correct. Let's take a deeper look.

Let's review the UCACFS net cash income line. Net cash income is the cash-basis income generated by Classic Candies. As stated earlier, net cash income is calculated by taking the basic income statement line items (sales, cost of sales, operating expenses, etc.) and making adjustments for the change in balance sheet accounts related to each revenue and expense line item (the balance sheet account related to sales/revenue is accounts receivable). If accounts receivable increase during the year, we will subtract the increase from the income statement sales/revenue to arrive at cash collected from sales. Conversely, if accounts receivable decrease, we will add the decrease to sales/revenue to arrive at cash collected from sales.

Here is the basic calculation for the UCA DSCR: Cash Available to Service Debt

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April 2010 The RMA Journal

Net cash income* + Interest expense ? Dividends/distributions = Cash available to service debt**

Debt Service Current maturities of long-term debt + Interest expense = Debt service

*Net income is taken directly from the UCA cash flow statement. ** Depreciation (and other noncash expenses and income) is not included in the calculation of net cash income. Therefore, adding back depreciation expense does not apply to this calculation.

Here are Classic Candies' UCA DSCR calculations for 2005?08. (For comparison purposes, the traditional DSCR is included at the bottom of the table.)

UCA DSCR Net Cash after Operations Dividends Cash Available to Service Debt Debt Service + CMLTD + Interest Expense Debt Service Net Cash Surplus/(Deficit) UCA DSCR Traditional ANI DSCR

2005 2006 2007 2008

81 229 (123) 1,581

(75) (75) (75) (100)

6

154 (198) 1,481

245

306

316

316

243

288

275

260

488

596

591 576

(482) (442) (789) 905

.01x .26x

n/a 2.57x

1.92x .76x 1.26x 1.23x

Compare the ANI and cash available to service debt under the two methods: UCACFS and traditional. There is a significant difference for each year. The UCA DSCR is significantly lower than the TDSCR for 2005, 2006, and 2007. For 2008, UCA DSCR is significantly higher than TDSCR. What caused these differences? Before reading ahead, take a few minutes to think about what can be causing the differences.

Comparing UCA and Traditional DSCRs Let's break down and compare the TDSCR and UCA DSCR calculations. The difference between the two ratios lies in the numerator of the calculation.

The primary reason for the differences between the TDSCRs and the UCA DSCRs is that the traditional ratio calculations do not include changes in balance sheet accounts. The UCA ratios do include the balance sheet changes.

Let's revisit UCA cash flow statement basics and the impact on cash of changes to accounts receivable and inventory.

From 2005 to 2008, there were significant changes in Classic's balance sheet accounts--particularly accounts re-

Traditional Adjusted Net Income Available to Service Debt

Net Income

555

(31)

252

154

+ Depreciation

211

265

295

395

+ Interest Expense

243

290

275

260

? Dividends

(75)

(75)

(75)

(100)

ANI Available to Service Debt

934

449

747

709

UCA Cash Flow Available to Service Debt

2005

2006

2007

2008

Net Cash after Operations

81

229

(123)

1,581

Dividends

(75)

(75)

(75)

(100)

Cash Available to Service Debt

6

154

(198)

1,481

Difference

(928)

(295)

(945)

772

Impact on Cash Flow

Source

Use

Asset Accounts

? Increase

x

? Decrease

x

Liability Accounts

? Increase

x

? Decrease

x

ceivable and inventory. Partially offsetting the receivables and inventory changes were changes in accounts payable. The increases in accounts receivable and inventory used significant amounts of cash from 2005 through 2007. In 2008, these assets decreased, resulting in positive cash flow for Classic. Let's look at the details.

Difference between Traditional ANI and UCA Cash Available to Service Debt Reconciliation of Difference (Increase)/Decrease in Accounts Receivable (Increase)/Decrease in Inventory Increase/(Decrease) in Accounts Payable Other Net Difference

2005 2006 2007 2008 (928) (295) (945) 772

(727) (199) (1,151) 532

(417) (175)

200

68

13

11

(928) (295)

26 330

113 (105)

67

15

(945) 772

The denominator (debt service) of both the TDSCR and UCA DSCR is the same, so there is no need to drill down into that part of the calculations. Let's compare the actual DSCRs under both methods.

Looking at the forest through the trees, what do the UCA numbers in the above tables tell us?

Traditional ANI DSCR UCA DSCR

1.91x .76x 1.26x 1.23x .01x .26x n/a 2.57x

Take a few minutes to review the numbers and also revisit the background information on Classic Candies included earlier in this article.

The RMA Journal April 2010

57

The numbers in the tables tell us that on a TDSCR basis,

Classic Candies generated sufficient ANI to service debt in

2005, 2007, and 2008.

Even after adjusting

(In 2006, there was a

the numbers to include the line borrowings, the

shortfall.) However, as the business grew and sales increased

DSCR for 2005 and 2006 are still "underwater"

over those years, the increases in accounts receivable and inven-

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