Topic outline
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Free cash flow
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.[1]
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 cash 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.
Loan life 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 1.7.
Earnings 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 potential.[2] Start with total revenue (or equivalently, total sales) and subtract operating expenses, including the cost of goods sold[3]. 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.
Earnings 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).
[1] Income 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])
[2] Similarly, 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?
[3] You 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.
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