What is a Debt Service Reserve Account?

What is a Debt Service Reserve Account and How do we Model It?

What is a Debt Service Reserve Account, or DSRA?

A Debt Service Reserve Account (‘DSRA’), is a reserve account specifically set aside to make debt payments in the event of a disruption of cashflows to the extent that debt cannot be serviced.  The DSRA is a key component on a financial model and is usually mandated in a lender term sheet.  The DSRA holds up to 12 months (or more) worth of debt service (both interest and principal), depending on the requirements of the lender to the deal.  DSRA’s can also changed over time, for example a lender might require 12 months of DSRA for the first few years of a project, and once cash flows have stabilised for the DSRA to decrease.

Sounds Simple…

A DSRA on the face of it is simple – forecast the debt payments expected over the next 6/12 months and put this money aside into a separate account.  If the debt payments increase or decrease, simply increase funding or decrease the balance of the DSRA.  What is so complicated about this?

Funding During a Construction Period

The first potential complication arises when we need to fund a DSRA while a project is in the construction period and does not have any cashflows.  The DSRA would then need to be funded out of a mixture of debt and equity, typically in the gearing ratio.  Remember, the DSRA needs to look forward and fund for the next 6 or 12 months of debt payments.  If the debt size increases, the interest and principal payments will increase and the DSRA will need to be bigger.  Wait for the difficult bit…

A DSRA can be complicated!

If we fund the DSRA out of debt – we will increase the debt, which will mean that interest and principal payments will increase.  This will in turn require us to increase the DSRA (to match the bigger interest and principal payments).  How do we fund this bigger DSRA?  Again, out of debt and equity, increasing the size of the debt required!  As you can see, this results in some circularities – we could go on for a while!

How do we resolve these circularities?

Excel Circular Reference

There are a few ways in which we can resolve these circularities – the easiest being a bit of VBA code.  The code continuously calculates the debt size and the initial DSRA (the first DSRA amount to be funded), until the required DSRA and the actual DSRA are the same amount.  It also copies and pastes values in the relevant places to remove the circularity issues in Excel.

What does a DSRA look like graphically?

The DSRA will look different depending on whether your debt payments are sculpted or paid in an annuity style.  Not sure what sculpted repayments mean?  Check out our tutorial on debt sculpting here.

Annuity Style DSRA

Let’s first assume you have annuity style payments, in other words the same total payments per month/quarter/year.  In this case, the DSRA will be fairly level until the debt is fully amortised.  It will be funded upfront – before debt payments even start to happen!

DSRA Annuity - Debt Balance vs DSRA

In the graph below, you can see the DSRA vs. the total debt payments.  Note that the DSRA is graphed on the right axis and is much bigger than the debt payments (in this example, 6 times the debt payments as debt payments happen monthly and we are funding 6 months’ worth!).

DSRA Annuity - Debt Payments vs DSRA

As we can see above, the DSRA balance will decrease towards the end of the debt life, as the next 6 months payments will become 5 months, 4 months, 3 months, 2 months and in the final period 0 months as there will only be one payment left before the loan is fully amortised.

Sculpted Payments DSRA

With a sculpted loan profile, the DSRA balance will change over time in line with the sculpted debt payments.  If the debt payments are increasing over time, so will the DSRA, as can be seen below.  Note that this isn’t always the case as revenue might vary over time or even decrease.  Sculpted simply means that the debt payments match the revenue or CFADS line, not that debt payments increase over time.

DSRA Sculpted - Debt Balance vs DSRA

Below you can see the DSRA increasing in line with debt payments increasing.  Note again that the DSRA is graphed on the right-hand axis and is much bigger than the monthly payment!

DSRA Sculpted - Debt Payments vs DSRA

Ok, but why have it at all?

Sure, a DSRA can create a cash drag even though it does earn interest.  Lenders will require a DSRA as a last resort to pay debt in the event of issues with the project – say an unexpected outage or maintenance needs to occur.  In such cases, the project can still cover debt payments with absolutely no revenue being generated for the DSRA period.  This gives everyone involved some comfort and the project enough time to sort out issues.

I hope this explained the basics of a Debt Service Reserve Account and why it exists.

Happy financial modelling!

Matthew

Matthew Bernath Financial Modelling


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