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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

http://cdn.playbuzz.com/cdn/2ddfb0f4-82ad-4a25-836b-537a1829c9f1/1c32942c-fc63-4bde-8cf9-0bc877301512.jpg

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 DepreciationALSO – 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??

http://www.uturnchurch.co.za/wp-content/uploads/2012/10/Good-Heart.jpg

Manu

Yes! Enjoy two Saturday holidays of Bankers!

Vinu

http://mrthorpe.global2.vic.edu.au/files/2014/04/wondering-18wkfa0.jpg

The author can also be reached at nrajca@gmail.com
Click here to access my online classes on Financial Management (English) (CA-IPCC)


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