Term loans are long tenure loans given for a period of 3 - 8 years for putting up a project.
Project may be
- Putting up a factory
- Construction of a building
- Purchase of Plant and machinery etc.
These projects are focused on
- Increasing sales or
- Reducing cost
so they can make a profit and service the loan using profits generated out of the project.
Measuring profit for servicing loans requires a special approach as there are various types of profits.
We have various types of profits like a
- Profit before interest and tax
- Profit before tax
- Profit after tax
- Profit after tax adjusted for non-cash items
- Profit after tax adjusted for non-cash items and interest.
Which profit we should consider for measuring debt repayment capacity?
That's where DSCR comes into the picture.
DSCR Stands for Debt Service Coverage Ratio.
It is calculated as follows.
DSCR = (Profit After Tax - Dividend + Interest on Term Loan + Depreciation or Amortization) / (Interest on Term Loan + Principle Amount)
There is a beautiful logic behind
- Why we are starting with PAT
- Why dividend is deducted
- Why interest on the term loan is added
- Why depreciation or amortization is added
- Why interest on term loan as added both in the numerator and denominator
- Why interest in working capital is not considered etc
All the above are discussed in depth in our course Banking Credit Analysis Process (for Bankers), where you can learn not only DSCR but also several connected topics like the letter of credit, bank guarantee, term loan, etc. Access 240+ Lectures of 20+ Hours Content.