Sanity test is a simple rule-of-thumb calculation to quickly evaluate whether a claim or result can possibly be true.
To illustrate, one of the attributes of a new carwash project is its ability to support debt. Lenders evaluate this ability with debt service coverage ratio (DSCR) which is a measure of a company's available cash flow to pay current debt obligations.
DSCR is calculated by dividing net operating income (NOI) and total debt service.
Consequently, we can use this relationship as sanity test to quickly determine if a proposed project makes financial sense.
The process for sanity test is apllied in several steps.
1. Estimate average monthly gross sales (i.e. $35,000)
2. Estimate expenses (i.e. express in-bay is 45% of gross sales)
3. Calculate NOI
NOI = $35,000 X (100% - 45%) = $19,250
4. Calculate maximum allowable payment (MAP)
MAP = NOI / 1.5 = $19,250 / 1.5 = $12,830
5. Estimate total cost of investment (i.e $1.0 million)
6. Calculate monthly mortgage payment (i.e. $6,000)
7. Compare estimated mortgage payment and MAP
If mortgage payment is less than MAP, then the project probably makes financial sense.