Loan Life Coverage Ratio (LLCR)

What Is the Loan Life Coverage Ratio (LLCR)?

The Loan Life Coverage Ratio (LLCR) is a standard tool used by lenders to check the solvency of a borrower by comparing project cash flows with outstanding loan payments. In addition, the analysis helps the lender understand the borrower's loan repaying capacity.

The financial ratio tells you how many times the project's cash flows can repay the outstanding loan amount; thus, it is tremendously useful.

A lender must be confident in the borrower's ability to make payments. Therefore, many metrics are used to make a judgment on the ability to repay the borrower. The metrics allow the lender to understand the risk of default for debt that could be issued.

The LLC is a metric that compares a borrower's potential cash flows from a project with outstanding payments that the individual or corporate borrower is obligated to make. Further, the cash flows to be received and made are discounted to the present.

A borrower is usually seeking financing for endeavors that may potentially create cash flows in the future. Thus, the borrower takes out a loan to invest in a project and then uses the income from that project to pay back the lender.

Any investment comes with much risk, as there is uncertainty regarding the success of the venture. Hence, lenders use the LLCR metric and their understanding to judge the borrower's capability to make back payments quickly.

This allows lending firms and individuals to issue debt that a borrower is most likely to be able to make while also serving their financing needs as much as possible. Of course, other factors, such as the borrower's creditworthiness and collateral assets, come into play.

However, overall, a lender can analyze the borrower's investment venture to understand the amount of potential income that will likely be generated based on past performance by discounting cash flows that are to be received in the future.

For a borrower, the ratio analysis can help estimate the risk of the project and compare competing projects with different cash flow timings.

Advantages and Disadvantages Of LLCR

Individuals using the ratio should be aware of many factors associated with the loan life ratio. This section will discuss these factors in depth to highlight the benefits and drawbacks of LLCR.

Here is a table with the benefits and limitations of the loan life ratio:

Perhaps the most beneficial factor associated with the loan life coverage ratio is that it is easy to interpret and apply. As a result, lenders can use the ratio as a covenant to monitor a borrower and put restrictions in place.

Moreover, the loan life ratio incorporates the time value of money in its analysis. This allows analysis to compare competing investments with different expected payout structures and schedules. Hence, it can be practical for investors.

However, a key disadvantage of calculating the ratio is that the forecasted cash flows can be much different than reality. Therefore, the individual conducting the analysis needs to have much experience and be transparent with themselves to create a sound analysis. 

Loan Life Coverage Ratio Uses

Financial ratios are used by a variety of parties to assess the financial well-being of an entity. This section will discuss the uses of the ratio from the perspectives of several parties. 

These parties are:

1. Lenders

Lenders can use the metric to understand the borrower's repayment capacity in different situations. For example, if a lender is considering issuing a new loan, they can analyze the borrower's diligence on a project and determine how much debt to issue using the metric.

On the other hand, a previously issued loan can be analyzed quickly by the lender to determine the current repayment ability of the borrower. 

For instance, changing market conditions may impact the project's future cash flows. Thus, new estimates can be used for reliable inference.

Therefore, analyzing previously issued loans using the metric gives a lender a reliable analysis that determines the new risk of default, which accounts for changing market and project-specific conditions.

For the reasons above, this ratio metric is commonly a covenant in loan agreements. 

2. Investors

Investors often incorporate the metric in their analysis to determine a firm's solvency status. In addition, the metric is handy for previously insolvent firms and is now in the turnaround process as it compares debt obligations with business cash flows.

Investors can also use the metric to analyze projects they consider. As mentioned, the LLCR metric discounts cash flows and allows comparable analysis between competing projects.

3. Borrowers

Borrowers themselves can run through a transparent analysis in difficult situations to understand their default risk. 

For example, if a firm is confident in its forecasts of declining business for a few coming years, rigorous business analysis can incorporate this metric.

If a borrower is aware that they are likely to miss a payment in the future and default, they can prepare for future difficulties by increasing liquidity and can temporarily hold off investments in more risky projects to safeguard against default.

Further, the borrower can go as far as to make additional payments on their debt than required. This is commonly seen by firms who predict that future cash flows will be lower than expected, as it allows them to meet covenants set by lenders for LLCR.

Moreover, the borrower can try to negotiate with their lenders to hopefully receive forbearance or favorable loan conditions, allowing the borrower to make flexible payments.

Therefore, the analysis conducted using the ratio can be used in many ways by different stakeholders to understand an entity's financial health. 

Loan Life Coverage Ratio Formula

The loan life coverage formula will be discussed in this section, followed by a breakdown to simplify the interpretation of the formula and its components.

Here is the formula:

LLCR = (NPV of CF Available to Service Debt + Cash Reserve)/Outstanding Loan Balance

Let's break the formula into its components:

1. Net Present Value (NPV)

The formula's Net Present Value (NPV) refers to the discounted value of all cash flows based on when they have been received and the discount rate.

Here is the formula for the NPV for only one cash flow:

NPV for one cash flow = (Cash Flow/(1+i)^t) - Initial Investment

Further, if you are analyzing a project with many cash flows for a longer period, then you can use this:

NPV for multiple cash flows = ∑n_t=0 Net CF/(1+i)​t

Net cash flows are the cash flows left after subtracting cash outflows.

For both formulas,

• Net CF = Cash Inflows - Cash Outflows
• t = number of time periods
• i = discount rate or required rate of return

The discount rate is simply the interest rate on a loan. It is sometimes referred to as the rate required by the investor because it can be used to evaluate the attractiveness of potential projects.

2. Cash Reserve 

If the borrower has cash or debt reserves such as savings to make payments on debt if needed, this can be included in the formula to reflect the borrower's true ability to make payments.

3. Outstanding Loan Balance

The outstanding loan balance is simply the remaining balance left to be paid on the loan by the borrower. Hence, it is the obligated amount due to the lender.

Interpretation of Loan Life Coverage Ratio

This section will cover the interpretation of the solvency ratio LLCR. Remember that the ratio is built on forecasts and thus depends on the sentiment of the person making the analysis.

As mentioned before, the financial ratio shows the payment ability of the borrower. Thus, it serves as an inference that indicates the number of items that a project's free cash flows can cover the debt.

Here are the interpretations of the ratio value:

Lenders usually issue debt that has a ratio of more than 1.25; this gives them enough headroom for any downside risk. Hence, a ratio that is equal to 1 would not mean that a lender necessarily provides the financing.

After issuance, lenders may make amendments to the standards they set for borrowers. For example, a lender may require a ratio of more than 2 to provide capital for particularly risky projects. These changes allow lending firms to manage their risk.

If the loan life ratio falls below 1, the borrowing firm will need to make out-of-pocket payments to the lender to cover all dues. This means that the investment is not generating enough cash flows to cover debt repayment. Hence net cash flows are negative.

Further, suppose a borrowing firm's ratio falls below 1. In that case, lenders will immediately take action that ensures that the loan amount is recovered, such as approaching the borrower and demanding for liquidation of collateral assets to compensate. 

In such cases, lenders usually place several covenants that allow them to pursue the borrower. Sometimes, they can declare the borrower to default if such a covenant is breached.

Investors would typically embark on projects with an expected LLCR value equal to or more than 1. But, of course, some investors may demand a higher return.

Overall, the higher the ratio, the better the repayment ability of the project in paying back debt.

Loan Life Coverage Ratio Example

Understanding the concepts and uses behind financial ratios can be difficult. This section will run through an example to illustrate the use case of the loan life ratio and discuss an interpretation for both lenders and borrowers.

Suppose you are an individual who owns a large firm involved in manufacturing essential goods. To grow your manufacturing output, you take out a loan worth $25 million to help finance a new factory that costs about $150 million.

You approach a lender with your requirements and showcase the following analysis of what you expect cash flows to look like from this investment. 

You decide to pay the debt back in increments of $5 million every year from 2025 to 2028, and for the final year, you plan to clear the remaining balance of $10 million.

Here is a table with the calculations of the ratio based on these forecasts:

CFDS represents the cash flow available for debt servicing. It is the net cash flow left after outflows that can be used to satisfy the lender. The sum of the CFDs per every quarter is discounted to the present using the NPV formula. 

Then, the NPV of the sum of cash flows available for debt servicing can be divided by the total debt outstanding to obtain the value of the loan life ratio.

The lender went through the request and approved the loan amount under several covenants, one of which does not allow LLCR to fall below one at any point. 

Given this covenant, you are expected to maintain higher cash reserves for the year 2025 to reduce the risk of breaching the covenant and thus defaulting.

Research and authored by Imran Husain | Linkedin

Reviewed and Edited by Hongmo Liu | LinkedIn

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