*Note: This article has an accompanying Excel file and podcast.
Debt sculpting is a powerful tool in debt structuring and project finance. Traditional debt repayments are the same total amount every time a payment is made, with the principal portion increasing with each instalment and the interest amount decreasing as the debt balance decreases. This annuity (or credit foncier for the fancier amongst us) payment methodology is common with house and car loans where the same amount is deducted from your bank account every month. The debt profile of such a loan would typically look as follows, amortising over time and decreasing at an increasing rate as the principal balance decreases:
The interest and principal payments sum to the same amount for each payment. If we had to graph the interest and principal payments in a stacked chart, they would look like this (the negative numbers indicate that payments are made):
I’ve spoken before about the Debt Service Coverage Ratio, or DSCR, which is a key component of debt sculpting. The DSCR is calculated as:
Suppose that your Cashflow Available for Debt Service (or CFADS), increases with inflation each year. One can then deduce that the DSCR is increasing on an annual basis, like this:
Now, let’s assume that we can adjust how much principal is paid on an annual basis. We could, therefore, increase the principal payment in line with how our Cashflow Available for Debt Service (or CFADS) is increasing, and not just with decreasing interest. This is the art of debt sculpting. CFADS may be increasing in line with our revenue line, for example at inflation. One could, theoretically, pay according to a payment schedule that looked like this:
To summarise so far, the annual payments in scenario one (equal total interest and principal payments) and the annual payments in scenario two (sculpted debt repayments) can be graphed against CFADS as follows:
From the graph above, you can see that there is still a healthy buffer between CFADS and our total debt payments. In fact, if we had to calculate our DSCR in the first debt payment period above, it would be the same for both scenario one and scenario two. It would be 1.30x (DSCR is always indicated with a ‘x’ or ‘times’ at the end of the number to indicate how many times covered you are).
In scenario two, we simply maintain a constant DSCR by increasing our debt payments, whereas in scenario one the DSCR is increasing as CFADS increases. This means the debt repayments are sculpted in line with CFADS. This can be graphed as follows:
Debt sculpting range from easy to complicated depending on your requirements, but in its simplest form one can use an equation to calculate what the principal payments should be.
Recall the DSCR formula:
If we want to target a DSCR of 1.40x, we can re-arrange the equation to look as follows:
Now take a look at the sculpting example to see how it can be done in Excel.
Good luck and happy financial modelling!