Term loan appraisal: DSCR, collateral and restructuring
Baraka Dairy Processors Ltd has applied to your bank for a KSh 25,000,000 five-year term loan at 16% p.a. to buy cooling tanks and expand milk collection. Audited 2025 figures show EBITDA of KSh 14,000,000, depreciation KSh 2,000,000, existing interest KSh 1,200,000, existing principal repayments KSh 1,500,000, maintenance capex KSh 800,000 and an increase in working capital of KSh 400,000. Tax is 30% and is paid in the year. The company proposes no equity contribution and has an existing term loan balance of KSh 5,000,000. Security is a first charge over land valued at KSh 35,000,000 by the bank's valuer, but the company also has a KSh 6,000,000 unsecured overdraft that is permanently at its limit, and debtors are running at 55 days against an industry norm of 35. Credit policy requires a minimum DSCR of 1.25x and maximum total debt to EBITDA of 3.0x. The relationship manager recommends approval, citing the collateral.
1. Compute cash flow available for debt service and the DSCR on the proposed terms. Does the proposal meet policy?
Read the worked answer
Step 1 - Tax. EBIT = 14,000,000 − 2,000,000 = 12,000,000. Interest 1,200,000 → PBT 10,800,000. Tax at 30% = 3,240,000.
Step 2 - CFADS. CFADS = EBITDA − tax − maintenance capex − working capital increase = 14,000,000 − 3,240,000 − 800,000 − 400,000 = KSh 9,560,000
Step 3 - New instalment. Annuity factor, 5 years at 16% = (1 − 1.16⁻⁵) ÷ 0.16 = 3.2743 Instalment = 25,000,000 ÷ 3.2743 = KSh 7,635,000
Step 4 - Total debt service. Existing interest 1,200,000 + existing principal 1,500,000 + new instalment 7,635,000 = KSh 10,335,000
Step 5 - DSCR. 9,560,000 ÷ 10,335,000 = 0.93x
Conclusion: the proposal fails the 1.25x minimum by a wide margin. CFADS covers less than the debt service - the business would have to fund the shortfall from reserves or from further borrowing, which is precisely the spiral the ratio exists to catch.
Leverage test: total debt = 25,000,000 + 5,000,000 + 6,000,000 = 36,000,000; 36,000,000 ÷ 14,000,000 = 2.57x, inside the 3.0x cap. Note the trap: the leverage test passes while the cash-flow test fails. Leverage measures size of debt; DSCR measures ability to repay it. On an amortising loan the DSCR is the binding constraint.
Caveat to disclose: the tax figure has been computed without the tax shield on the new interest, which understates CFADS slightly. Including it would add roughly KSh 1.0–1.2m and lift the DSCR to about 1.03x - still a clear fail, so the conclusion is unaffected.
2. Evaluate the relationship manager's reliance on the KSh 35,000,000 land valuation.
Read the worked answer
Collateral is the second way out, not the first. The primary repayment source is operating cash flow, and at 0.93x that source is insufficient. The RM has inverted the order of analysis.
Specific weaknesses in the collateral argument:
- Coverage is less impressive than it looks. The land secures the KSh 25,000,000 term loan, but the KSh 6,000,000 overdraft is unsecured and pari passu in economic substance - it is funded by the same cash flow. On a forced-sale basis the valuer's figure should be haircut (typically 20–30% for a dairy-industrial site with limited buyers), giving a realisable KSh 24.5m–28m against total debt of KSh 36m. The apparent 140% cover shrinks to roughly 75–95%.
- Enforcement destroys the borrower. Seizing the cooling tanks and land stops milk collection; the security's value depends on the business continuing. Collateral that can only be realised by killing the cash flow is weak collateral.
- The collateral does not fix the cause. The 0.93x DSCR arises from a large new instalment relative to a modest EBITDA and from leakage into working capital - 55 debtor days against a norm of 35 ties up roughly KSh 3–4m of cash that would otherwise service debt. No amount of land corrects that.
- The overdraft at its limit is the real warning. A permanently fully-drawn unsecured overdraft indicates the operating cycle is not self-funding. Lending a five-year term loan to a business in that position converts a short-term liquidity problem into an illiquid long-term one.
Conclusion: the RM's recommendation should not be accepted. Collateral supports a decision that the cash flow already justifies; it cannot substitute for one. Recommend declining on the terms requested and placing a restructuring proposal to the credit committee.
3. Recommend a structure that could meet the 1.25x policy minimum, with conditions.
Read the worked answer
Test the restructuring options against the same KSh 9,560,000 CFADS.
| Option | Instalment | Debt service | DSCR | Verdict |
|---|---|---|---|---|
| As proposed, 5 yrs, KSh 25m | 7,635,000 | 10,335,000 | 0.93x | Fail |
| 7 yrs, KSh 25m (AF 4.0386) | 6,190,000 | 8,890,000 | 1.08x | Fail |
| 8 yrs, KSh 25m (AF 4.3436) | 5,756,000 | 8,456,000 | 1.13x | Fail |
| 8 yrs, KSh 20m (AF 4.3436) | 4,605,000 | 7,305,000 | 1.31x | Pass |
| 7 yrs, KSh 20m (AF 4.0386) | 4,952,000 | 7,652,000 | 1.25x | Marginal - no buffer |
Recommendation: approve up to KSh 20,000,000 over 8 years at 16%, conditional on the borrower injecting KSh 5,000,000 of equity (the shortfall against the KSh 25m requirement). This gives 1.31x with a modest buffer above the 1.25x floor. The 7-year variant technically passes but leaves nothing for a bad milk-price year - do not present a covenant with zero headroom.
Conditions to attach:
- Owner equity of KSh 5m paid in and verified before first drawdown; loan drawn in tranches against invoices for the tanks.
- The KSh 6,000,000 overdraft cleared or reduced to an agreed limit from the proceeds and from debtor collection, with a formal overdraft facility letter. A permanent hard-core overdraft is not working capital.
- Debtor days reduced from 55 to 40 within two quarters and to the 35-day norm within four, with monthly ageing reports to the bank. This releases roughly KSh 3–4m and lifts CFADS independently of the loan structure.
- First charge over the land, plus a debenture over receivables and the tanks, and assignment of the milk supply contracts.
- Financial covenants tested quarterly: DSCR ≥ 1.25x and total debt to EBITDA ≤ 3.0x, with a cash sweep of 50% of surplus above the covenant level.
- Six-monthly management accounts, audited accounts within four months of year end, and a monitoring trigger if EBITDA falls 15% below projection.
Note the limits of the model: the CFADS figure is a single historical year. Before approval, obtain three years of projections with sensitivity to milk price and to a 10% volume shortfall, and confirm the tanks generate the assumed collection increase - otherwise the bank is lending against EBITDA that will not grow.