Understanding the Loan Life Coverage Ratio – what it is and how it is calculated

Calculating the Loan-to-Life Coverage Ratio

A coverage ratio is a metric for determining whether or not a borrower can pay back its debts. Companies and lenders use it to assess a borrower’s ability to pay back a loan, particularly for specialized projects. Commonly, lenders use the Loan Life Coverage Ratio (LLCR) as an indicator of whether the project has the ability to pay back the money it borrowed. LLCR is determined by dividing projected cash flows by the entire amount of outstanding debt, using a discount factor.

Incremental cash flow analysis is used to determine a project’s capacity to repay its financing. Because of this, discounted cash flows provide a more accurate estimation of the project’s risk. Using a discounting procedure, these cash flows will be sorted out and the competing projects will be prioritized.

The formula for calculating the LLCR

LLCR employs the discounted cash flows of the project in the numerators. Cash or any other specified reserve made to pay the loan is also included in the analyst’s discounted cash flows. Cash flows and reserves are added together and divided by “total outstanding debt” or “debt that must be paid off.”

Cash discounted cash flows available for debt payment + Cash reserve/Debt outstanding is the LLCR formula:

A company’s net long-term return (LLCR) may be determined at any time. After 10 years, the remaining time might be determined either yearly, semi-annually, or quarterly, depending on how long the loan has been taken out. The cost of the loan is the discounted rate, which is the rate at which the company has borrowed the money.

The LLCR’s interpretation

The greater the LLCR ratio, the more advantageous it is to the lender. Having a 1x cash flow ratio means that the project’s cash flow equals the amount of the outstanding loan. Higher ratios imply more cash flow from the project compared to the amount of outstanding debt. Having a debt-to-equity ratio of less than one is a bad indicator for the lender, on the other hand As a result, the discounted cash flows and the cash reserves are insufficient to pay all of the outstanding loan balance. The lender may impose restrictions or require a cash reserve if the project is deemed too risky. The lender will be relieved and the risk profile of the project will be reduced as a result of this. To put it another way: greater ratios mean lower risks and hence better returns for lenders.

Loan-to-debt service coverage ratio against loan life coverage

The formula is where the biggest difference may be found. For the purpose of computing LLCR, we utilize anticipated cash flows for debt service and outstanding debt payments. The Debt Service Coverage Ratio, on the other hand, considers both cash and non-cash expenditures when calculating net operating income. Interest payments and principle repayments make up debt service here.

Additionally, LLCR calculates a firm’s solvency by looking at the company’s future cash flows, which is a major distinction. The debt payment coverage ratio, on the other hand, is based on net operating income from a certain year. As a result, DSCR looks at how long the firm or project has been in business before making an assessment of its solvency. LLCR is a stronger determinant of a project’s or a company’s long-term financial health.

Measures of short-term position are often based on the DSCR formulae.

Comparing the Loan Life Coverage Ratio with the Project Life Coverage Ratio

To determine the project life coverage ratio, divide the project’s net present value by the project’s debt service. Lenders often establish a minimum floor for the PLCR ratio since it lowers the risk of lending. The reserve is not included in the project life coverage ratio, as it is in the Loan life coverage ratio. Additionally, LLCR employs discounted cash flows accessible to the company, while PLCR uses NPV ( the Net present value is the discounted cash flows of the project, subtracted from the initial cost of the project). As a result, a project with a positive net present value (NPV) is preferable to one with a negative net present value (NPV).

There are three criteria lenders use to determine a company’s ability to repay its loans: loan life coverage, project life coverage, and the debt service coverage ratio. It helps them see the overall picture and plays an important part in determining the project’s risk profile.

Example

Particulars2020202120222023
PV of CFDS (2020)100
PV of CFDS (2021)140.2150.0
PV of CFDS (2022)174.7186.9200
PV of CFDS (2023)204.1218.4250
Net Present Value618.9553.3200.0250.0
Debt Outstanding450300
LLCR1.381.85

Cash flow for debt service in the fiscal year 2020 is $618.9, and in the fiscal year 2021, it is $553.3. In this case, the discount rate is 7. The net present value is divided by the outstanding debt to arrive at the LLCR. The lender has a good outlook for 2020 since the ratio is 1.3. The fact that this number is higher than one suggests that the company has sufficient cash flow to pay down its debt. In 2021, the position of solvency will be enhanced by 1.85 times. proving the project’s good side once again. A lower debt quantity has also led to a rise in the debt-to-equity ratio.

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