This is a brief introduction to a Debt Service Reserve Account (DSRA). It is an extract from Pivotal180’s project finance courses:
Renewable Energy Project Finance Modeling Infrastructure and Project Finance Modeling and Mining Project Finance Modeling
If you work in project finance, this is a must-know concept!
Having come this far in the course, you’re familiar with our three core concepts of project finance being, one, it’s all about longterm promises of cash flow.
The project is worth something so long as it’s operating, generating us cash flow.
Number two, risk sharing is allocated in contracts to capable parties best able to deal with that risk and
number three, it’s non-recourse to the project sponsors. So what happens if a project doesn’t go to plan and there isn’t enough money to repay the lenders? The lenders only have recourse to the project cash flows. They can’t go back to the sponsors, even if it’s the Queen of England, or Bill Gates, because it is non-recourse. So any protection available for the lenders needs to be at the project level.
So let’s consider an example. We have a project that’s expected to generate revenue of 20 million per annum. In year one, we earn that 20 million of revenue, exactly as forecast, but in year two we only get 16 million. That’s four million less than expected. In year three, we earn 24 million of revenue, recovering the lost $4 million of revenue from year two. We had here a temporary issue that reduced our revenue in year two, so let’s investigate the impact on debt service. Our costs are $8 million every year, and in year one things went nicely to plan, and CADS was 20 million, less eight million, which equals 12 million. Debt was also sculpted to a 1.33 DSCR and then fixed. So at 12 million divided by 1.33, equaling nine million per annum. So, our DSCR in year one is 1.33. However, in year two, our CADS is only eight million, one million less than our debt service, and our DSCR is 0.89 times. In year three, CADS is now 16 million, much higher, so our DSCR is 16 divided by nine, which equals 1.77. And our average DSCR is the total of CADS of 36 million, divided by the total debt service of 27 million, which equals 1.33.
Oh, nice. The average DSCR is exactly where we want it to be, so everything’s great, right?
No, sorry. If the project can’t pay its debt in any given year, it’s in default. But it’s not all bad. Well, at least if the project was structured well. If the project had failed completely, perhaps not even operating from year two onwards, there isn’t much a lender can do to protect themselves, but in this situation, the lender could allow themselves some breathing room, by setting an amount of spare cash in the project that can be used to pay that $1 million shortfall in year two. And as we have this spare, or reserve of cash, to pay this shortfall in debt service, the project doesn’t go into default.
This cash, or reserve of cash, is called a Debt Service Reserve Account, or DSRA. So what is a DSRA? It’s a cash account that retains money for when CADS is too low to service debt. This account is cash security for the lenders, so the lenders will monitor the amount within the account. And the DSRA needs to maintain enough cash in it to pay for debt service when CADS is too low, and this amount it needs to retain is called a target balance.
The Debt Service Reserve Account is a pretty complex part of a project finance model, and so before we start doing any calculations, we should really first try to understand the four elements of a DSRA account.
Details on how to calculate these elements will come in the next lesson, but for starters, the four elements are,
first, we’re going to calculate our DSRA target balance.
Then second, if the DSRA balance is below the target balance, we will fund it from any cash that we have available for funding.
And then third, if there isn’t enough cash available to pay debt service, then the DSRA will release money in order to pay that debt service shortfall. That’s really the core purpose of the DSRA.
And then, fourth, if the DSRA balance is greater than the target balance that we need, the extra money in the DSRA account can be released into the waterfall.
From a best practice standpoint, we would build a control account record as we’re monitoring a volume of cash flow over time for each of these four instances. Now, remember, lenders will always want to check if the DSRA is in compliance with the facility agreement, and so we’re also going to need to add some checks as to whether we’re in breech of a covenant.
The DSRA is just a cash account with money set aside to pay debt service if CADS is too low. In the next lessons, we will do the calculations for each part of the DSRA together.
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