One operating year run through every account to the cent, then the same year with 10 per cent less revenue and the distribution gate shut.
A project finance cash flow waterfall pays revenue out in a fixed order: operating costs and tax, reserve transfers inside CFADS, senior interest and principal, the debt service reserve top-up, and only then the equity, and only if the cover ratio passes the distribution test. On an illustrative year with 54.00 of revenue, CFADS of 34.55 covers debt service of 26.00 at 1.33x and the sponsor receives 8.35. A 10 per cent revenue fall cuts CFADS by 11.7 per cent, takes cover to 1.17x under a 1.20x lock-up, and cuts the distribution to zero.
Worked in full in The Project Finance Handbook by Julian R. Sterling, with every figure reproduced in a free workbook.See the book on Amazon →
An operating renewable project in a normal year, financed with an amortising senior loan. The accounts agreement sets up the usual structure: a revenue account that receives everything, a major maintenance reserve account (MMRA) funded inside CFADS, a debt service reserve account (DSRA) sized at six months of the next year's debt service, and a distribution account that can only be reached through the lock-up test. All figures are illustrative, in millions.
| Input | Value |
|---|---|
| Revenue (base year) | 54.00 |
| Operating costs | 14.60 |
| Tax depreciation | 16.00 |
| Tax rate | 25% |
| Transfer to the MMRA | 2.00 |
| Senior interest | 12.00 |
| Scheduled principal | 14.00 |
| Next year's debt service | 26.40 |
| DSRA balance at the start of the year | 13.00 |
| Distribution lock-up (historic DSCR) | 1.20x |
| Event of default (historic DSCR) | 1.05x |
Each step takes what it is owed from what is left after the step above it. Nothing lower down is paid until everything higher up is paid in full, which is the whole point of the structure: the lender is senior not only in a liquidation but every single period.
1. Operating costs: 54.00 − 14.60 = 39.40 (EBITDA)
2. Cash tax: (39.40 − 16.00 depreciation − 12.00 interest) × 25% = 2.85
3. MMRA transfer: 2.00, so CFADS = 39.40 − 2.85 − 2.00 = 34.55
4. Senior debt service: 12.00 + 14.00 = 26.00; DSCR = 34.55 / 26.00 = 1.33x; left 8.55
5. DSRA top-up: target 6/12 × 26.40 = 13.20, balance 13.00, top-up 0.20; left 8.35
6. Lock-up test: 1.33x ≥ 1.20x, so the 8.35 moves to the distribution account
Excel, with the cash left after step 5 in F12 and the DSCR in F9: =IF(F9>=Lockup,F12,0) for the distribution and =IF(F9<Lockup,F12,0) for the cash trapped.
Two conventions are worth fixing before anything is modelled. The MMRA transfer sits inside CFADS here, as most agreements put it, so the cover ratio is measured after the money set aside for the next overhaul; the build-up of CFADS itself is set out in how to calculate CFADS in project finance. And the DSRA top-up sits below debt service: the reserve is refilled from what is left after the lenders have been paid, because it exists to pay them in a later period, not this one. Sizing that reserve, and whether a letter of credit is cheaper, is worked in how to size a DSRA.
Now run a year with 10 per cent less revenue, the kind of shortfall a poor resource year or a weak merchant tail produces. Operating costs do not move and debt service does not move, so every unit of lost revenue falls through to the bottom of the waterfall, softened only by lower tax.
| Step | Base year | Revenue −10% |
|---|---|---|
| Revenue | 54.00 | 48.60 |
| Less operating costs | −14.60 | −14.60 |
| Less cash tax | −2.85 | −1.50 |
| Less MMRA transfer | −2.00 | −2.00 |
| CFADS | 34.55 | 30.50 |
| Less senior debt service | −26.00 | −26.00 |
| DSCR | 1.33x | 1.17x |
| Less DSRA top-up | −0.20 | −0.20 |
| Cash after reserves | 8.35 | 4.30 |
| Distributed to equity | 8.35 | 0.00 |
| Trapped in the lock-up account | 0.00 | 4.30 |
CFADS falls by 4.05, or 11.7 per cent. The distribution falls by 100 per cent. The project is not in default, it pays its lenders in full and it still has 4.30 of surplus cash, but the 1.17x cover is below the 1.20x gate, so the surplus is held in a blocked account. Under most agreements it is released if the test is passed again, often on two consecutive test dates, and applied to a cash sweep of the loan if the lock-up persists for longer than the agreed number of periods.
A lock-up level means little until it is turned back into revenue. The test fails when CFADS drops below 1.20 × 26.00 = 31.20, which is 3.35 below the base year. With tax at 25 per cent of a positive taxable profit, CFADS moves by 0.75 for each unit of revenue, so:
CFADS = 0.75 × (revenue − opex) + 0.25 × (depreciation + interest) − MMRA
Lock-up revenue = (31.20 + 2.00 − 0.25 × 28.00) / 0.75 + 14.60 = 49.53
Cushion = 54.00 − 49.53 = 4.47 of revenue, an 8.3 per cent fall
The same arithmetic at 1.05x gives a revenue fall of 17.9 per cent before the ratio default. The sponsor's dividends therefore sit behind a cushion less than half the size of the lenders' own.
| Revenue fall | CFADS | DSCR | Distributed | Trapped | Status |
|---|---|---|---|---|---|
| 0% | 34.55 | 1.33x | 8.35 | 0.00 | Distribute |
| 6% | 32.12 | 1.24x | 5.92 | 0.00 | Distribute |
| 10% | 30.50 | 1.17x | 0.00 | 4.30 | Lock-up |
| 14% | 28.88 | 1.11x | 0.00 | 2.68 | Lock-up |
| 20% | 26.45 | 1.02x | 0.00 | 0.25 | Ratio default |
Two features stand out. The distribution is a cliff, not a slope: between a 6 and a 10 per cent fall it goes from 5.92 to nothing. And at a 20 per cent fall the project still covers its debt service in cash, with 0.25 left over, yet it has breached the 1.05x default ratio. Default in project finance is usually a ratio event long before it is a payment event, which is why the DSRA is rarely touched in the first bad year.
The frequent modelling error is to pay equity CFADS minus debt service in every year. In the base year that overstates the distribution only by the 0.20 DSRA top-up, which is easy to miss. In the weak year it books 4.50 of dividends that the accounts agreement will never release on time, and an equity IRR built on that line is wrong in exactly the years that matter. Model the gate explicitly, carry the trapped cash in its own account, and decide where it goes: released later, swept to the lenders, or used to cure.
The waterfall with its five accounts and the gate is laid out as a working document with the free workbook for this case, and the project finance model template runs the same order of payments over the whole loan life.
It is a test, usually on historic and sometimes projected DSCR, that must be passed before cash can move from the waterfall to the shareholders. In the worked case the lock-up is 1.20x: at 1.33x the sponsor receives 8.35, at 1.17x the 4.30 left after debt service and reserves is held in a blocked account, released if the test is passed again or swept to the lenders if the lock-up persists.
After. The waterfall pays scheduled interest and principal first, then refills the debt service reserve to its target, typically six months of the next period's debt service. In the example the target is 13.20 against a balance of 13.00, so 0.20 is taken after the 26.00 of debt service and before any distribution.
Turn the lock-up ratio into CFADS, then into revenue. A 1.20x test on 26.00 of debt service needs CFADS of 31.20. With tax at 25 per cent, CFADS moves 0.75 per unit of revenue, so revenue can fall from 54.00 to 49.53, or 8.3 per cent, before distributions stop, against 17.9 per cent before the 1.05x default ratio.
This article is one calculation from The Project Finance Handbook. The book takes the same case from first principles to the decision, chapter by chapter, and every figure it prints is a live formula in the free companion workbooks.
Get the book on Amazon →Free companion files
Also on Amazon UK · Amazon Germany · Amazon France · Amazon Canada
Reading guide: infrastructure, data centres and energy → · All 681 articles →
If this book helped, or didn’t, a few lines on Amazon are worth more than they look: they are what the next reader goes on. Write a review. The workbook stays free either way.