What is the Loan Life Coverage Ratio (LLCR)?

What is the Loan Life Coverage Ratio (LLCR)?

The loan life coverage ratio (LLCR) is a financial ratio used to estimate the solvency of a firm, or the ability of a borrowing company to repay an outstanding loan. LLCR is calculated by dividing the net present value (NPV) of the money available for debt repayment by the amount of outstanding debt.

LLCR is similar to the debt service coverage ratio (DSCR), but it is more commonly used in project financing because of its long-term nature. The DSCR captures a single point in time, whereas the LLCR addresses the entire span of the loan.

Calculation of Loan Life Coverage Ratio

In the numerators, LLCR uses the discounted cash flows of the project. Along with the discounted cash flows, the analyst also adds cash or any other specific reserve created to service the debt. The number is achieved by adding the cash flows and reserves and then dividing it by ‘total outstanding debt’ or the remaining debt that is needed to be paid off.

LLCR = (Sum of Cash discounted cash flows available for debt service+ Cash reserve) / Outstanding debt

LLCR can be calculated at any point in time. If the loan is taken for a total of 10 years, it can be calculated when the remaining time is 5 years, either annually, semi-annually, or quarterly. The discounting rate is the rate at which the firm has borrowed the loan, that is the cost of the loan.

Why is the Loan Life Coverage Ratio (LLCR) Important?

Similar to the debt service coverage ratio (DSCR), the LLCR is an important ratio used in project finance. In any project finance undertaking, calculating both ratios is a standard step in assessing the project. However, unlike the DSCR, which measures the project’s ability to pay debt period-on-period, the LLCR takes into account multiple periods of cash flow available for debt service, as well as the entire amount of debt outstanding.

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LLCR assesses the project’s ability to pay off all debt obligations based on the discounted projected cash flows. It gives a better estimation of the risk profile of the project as a whole.

Significance of Loan Life Coverage Ratio

  • LLCR < 1.0x: An LLCR that is less than 1.0x means that the project’s free cash flows are insufficient to support the amount of leverage that is being modeled and it will therefore be unable to service its loan within the Loan Life.
  • LLCR > 1.0x: This suggests that the project cash flows are sufficient to service debt. However, to be comfortable, lenders will look for atleast 1.25x LLCR at the start of the loan life and depending upon the riskiness of the project, this could go to 2.0x – 2.5x.

In the LLCR calculation example above, you will note that the LLCR for Years 1 to 4 is more than 1 signifying the debt can be repaid within its loan life, however in Year 5 it goes down to 0.95x meaning that it does not have enough free cash after paying interest.

This trend in LLCRs is typical in case the debt has not been sculpted properly. As the cash flows in the previous years are higher, it could have easily been sculpted such that more of it was repaid in the earlier years allowing the LLCR in Year 5 to be higher.

Interpretation of Loan Life Coverage Ratio

In the case of LLCR, the higher the ratio is the better it is for the lender. A 1x ratio indicates that the project’s cash flows are equal to the outstanding loan amount. While a higher ratio indicates that the project’s cash flows are higher than that of the outstanding debt amount. On other hand, a ratio of less than one poses a risky sign for the lender.

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It means the discounted cash flows plus the cash reserves are lesser than the outstanding amount and is not enough to cover the outstanding loan amount. Sometimes when the lender finds the project risky then he/she imposes covenants or can also demand maintenance of cash reserve. This will give comfort to the lender and reduce the risk profile of the project for the lender. Hence, the higher the ratio, the less risk and it is better for the lender.

Limitations of Loan Life Coverage Ratio

One limitation of the LLCR is that it does not pick up weak periods because it basically represents a discounted average that can smooth out rough patches.

For this reason, if a project has a steady cash flows with a history of loan repayment, a good rule of thumb is that the LLCR should be roughly equal to the average debt service coverage ratio.