We welcome your comments and questions.  Here’s a question from one of our readers:

“I frequently come across credits that have a substantial amount of non-cash interest expense related to hybrid financial instruments.Specifically, the one I have in mind has subordinated mezzanine financing with warrants attached.  Embedded in the company’s interest expense is “change in fair value of warrant liability” and “amortization of discount and issuance costs on notes payable”.

In a few of your recent articles (Comments on Credit and RMA) there is some mention of this kind of debt in relation to subordination agreements etc., but I cannot find a good explanation of how to calculate debt service coverage ratios on firms that have these kinds of instruments.

We frequently syndicate our transactions with other traditional commercial banks and in their analysis I’m finding that they don’t exclude non-cash interest expense like this out of their debt service calculations.  Some of the banks are more sophisticated than others, but I get the feeling that a lot of them don’t frequently deal with companies like this.

Can you provide any clarity on how one should debt service in a company like this?  I can see cases for both excluding and including the expense, but would really like to get your perspective and see if there is something I’m missing.”

Here’s our response:

The two non-cash items that we see most often included in interest expense on a company’s income statement are:

1) Amortization of discount and issuance costs (sometimes called deferred or capitalized financing fees) – very common, but typically very small

2) Accrued and capitalized interest on zero coupon debt or “payment in kind” (or “PIK”) debt – not very common, but sometimes used by higher risk companies

Mezzanine debt is typically used by high-risk, middle market and smaller companies.  The total return expected by mezzanine investors is in the mid to high teens.  Since borrowers typically can’t afford to pay that much cash interest, mezzanine debt includes other non-cash compensation, including original issue discount (“OID”), PIK interest, and equity warrants.  The cost of these items (cash or not) must be included in interest expense in each year.  They typically are not broken out on the income statement, but should be detailed in the footnotes.

Now to your question.  Non-investment grade and middle-market borrowers typically have a coverage covenant in their bank debt.  It may be:

Most often, the interest part of this formula is interest expense, right off of the income statement (i.e. including any non-cash interest amounts).  However, as with any type of ratio analysis, covenant formulas should be adjusted to fit the unique characteristics of each borrower.  For example, retailers with lots of rent expense typically use EBITDAR Coverage (i.e. EBITDAR / Interest + Rent) instead of EBITDA Coverage.

If a company has a lot of non-cash interest, we recommend (and often see) the coverage ratios adjusted to include only cash interest expense (i.e. excluding amortization of issuance costs, capitalized interest, etc.).  Here’s why:  we see coverage as a measure of liquidity – will the company have enough cash to pay its short-term financial obligations?  As such, the closer you can get to cash measures, the better.

Of course, EBITDA isn’t really a cash measure, but that’s a topic for another day …