Free cash flow, which is the amount of cash
available to reward the investors of the company. This is the cash generated
and available after paying all other stakeholders to pay dividend to
shareholders and repayment on loans.
Debt-Service Coverage Ratio (DCSR)
DSCR is a ratio meaning it
compares two things. One is the free cash flow and the other is the total debt
services. This refers to current debt obligations, meaning any interest, principal and lease payments that are due in the coming year. On a balance
sheet, this will include short-term debt and the current
portion of long-term debt.
In formula: DSCR = available free cash flow /
total debt services.
Lenders will routinely assess a
borrower's DSCR before making a loan. A DSCR of less than 1 means negative
flow which means that the borrower will be unable to
cover or pay current debt obligations without drawing on outside
sources—without, in essence, borrowing more. For example, DSCR of .95 means
that there is only enough net operating income
to cover 95% of annual debt payments. Typically, a DSCR greater than 1
means the entity – whether a person, company, or government – has
sufficient income to pay its current debt obligations. A DSCR of 1.3 or more gives a good comfort
feeling to the lender.
coverage ratio (LLCR) and Project life coverage ratio (PLCR)
Lenders have different ways of looking at
loans they issue. Another instrument they use is the LLCR. A ratio of 1.0x
means that LLCR is at a break-even level. The higher the ratio, the less
potential risk there is for the lender. Project financing agreements invariably
contain covenants that stipulate LLCR levels.
The LLCR uses Net Present Values of free cash flows over the entire
period of the loan. It of course needs to divide these then also by the Net
Present Value of total debt. In formula: LLCR = NPV
of available free cash flow over the entire loan period/ NPV of total debt. As
a rule, the LLCR should be greater than 1.7.
The PLCR is quite similar to the LLCR. The
only difference is that instead of looking at the entire period of the loan, it
is based on the entire project period. Thus it uses Net Present Values of free
cash flows over the entire period of the project. It of course needs to divide
these then also by the Net Present Value of total debt. In formula: PLCR = NPV of available free cash flow over the entire project
period/ NPV of total debt. As a rule, the PLCR should be greater than
Before Interest & Tax – EBIT
EBIT is a useful metric for
certain applications. For example, if an investor is thinking of buying a firm
out, the existing capital structure is less important than the company's earning
Start with total revenue (or equivalently,
total sales) and subtract operating expenses,
including the cost of goods sold. In the simplest terms, EBIT is calculated by taking the net income
figure from the income statement and adding the income tax expense and interest expense back
in. Put a different way, operating expenses are subtracted from total revenue.
Before Interest, Taxes, Depreciation and Amortization - EBITDA
EBITDA is used as
a proxy for the earning potential of a business, although doing so can have
drawbacks. EBITDA strips out the cost of debt capital and its tax effects by
adding back interest and taxes to earnings. The drawbacks of EBITDA:
it allows for an amount of discretion in what is and what is not
included in the calculation. This also means that companies often change the
items included in their EBITDA calculation from one reporting period to the
next. EBITDA is a good metric to evaluate profitability but not cash flow.
For example: A retail company generates $100
million in revenue and incurs $40 million in product cost and $20 million in
operating expenses. Depreciation and amortization expense amounts to $10
million, yielding an operating profit of $30 million. The interest expense is
$5 million, leading to earnings before taxes of $25 million. With a 20% tax
rate, net income equals $20 million after $5 million in taxes are subtracted
from pretax income. Using the EBITDA formula, we add operating profit to
depreciation and amortization expense to get EBITDA of $40 million ($30 million
+ $10 million).
taxes complicate DSCR calculations because interest payments are
tax deductible, while principle repayments are not. A more accurate way to
calculate total debt service is therefore: Interest
+ (Principle / [1 - Tax Rate])
if an investor is comparing companies in a given industry that operate in
different tax environments and have different strategies for financing
themselves, tax and interest expenses would distract from the core question:
how effectively do these companies generate profits from their operations?
may take out one-time or extraordinary items, such as the revenue from the sale
of an asset or the cost of a lawsuit, as these do not relate to the business' core
operations, but these may also be included. If a company has non-operating income, such
as income from investments, this may be—but does not have to be—included; in
that case, EBIT is distinct from operating income, which, as the name
implies, does not include non-operating income.