Two Views Are Better Than One: A Case Study Compares Two Methods for Calculating and Analyzing Debt Service Coverage Ratios
Grady, John T., The RMA Journal
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 creme-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.
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:
Income statement highlights:
1. Sales increased from 2005 to 2007 due to the introduction of the Brown Bear fund-raising product line. Sales dropped in 2008 due to the dropping of certain slow-paying 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. …