We’ve been running a poll on the Comments on Credit blog for the past few months asking 2 questions:
It is no surprise that bankers like the debt service coverage and fixed charge coverage ratios best – they are good measures of a company’s ability to pay its financial obligations as they come due (without relying on external financing). We think they are the best ratios to measure a company’s liquidity (much better than the current and quick ratios, but that is a topic for another post).
If debt service coverage and fixed charge are the best measures of coverage (and liquidity), the real question is why we don’t use them more often in covenants? The most used coverage covenant (in our survey and in our experience) is EBITDA coverage.
Accuracy vs. Simplicity
Whenever we look at ratios, for analytical purposes or for covenants, there are always the conflicting goals of accuracy and simplicity. We could write a ratio that looks at a company’s internally generated cash flow (say, free cash flow) relative to all of its future, normalized financial and operating cash outflows, but by the time we write the definition into a credit agreement it would be too long and cumbersome. As it is, we’ve see fixed charge coverage definitions that exceed one full page of (very small) text. And even then, there may be disagreements between borrower and lender about how it should be calculated.
So, in order to make the numbers easy to calculate and avoid disputes in the future, we sometimes go with simpler covenants, even if they are not the best measures of a company’s risk. Thus, EBITDA coverage is used more often than debt service coverage.
The overall monitoring of a borrowers financial results is very important. The Poll conducted highlights the most commonly used and obviously preferred ratios.
Defining financial covenants as requirements within debt documents / instruments is usefull in the management of the underlying transaction in the measure that the requirement is actually enforced. Granting waivers to financial covenants in a constant manner eventually makes it moot to include them all together in loan documents.
Therefore, regardless of the ratios used, its enforcement is of utmost importance.
It’s very important to have the specific loan covenants spelled out in the loan agreement. You should also include the requirement for the submission of a covenant compliance letter by the borrower on the frequency that the covenants are to be measured and signed by the borrower. When the compliance letter is received by the bank either the lender or credit analysis should run a recheck of the calculations to confirm them and note on the covenant compliance checklist if they are in compliance as well as the number of times they have not been in compliance.
If a covenant compliance waiver is requested by the borrower (in most cases there may be a going concern problem on FYE financials if the waiver is not granted). Covenants should be reviewed at the time of a renewal or review of the borrower’s outstandings. Reason? development of a watch list credit or worse.
For an operating company, the UCA cash flow should be used. There are covenant definitions for each method easily found by searching Google or RMA.
The best coverage ratio is the debt service ratio this would provide the ability of the debtor to pay obligations without the need for external/bank financing. We flucuate between EBITDA, Debt Service and New Worth regarding the later. A number of factors dictate the change in debt covenants however one should mirror the other.
Just witnessed a company go BK a year ago but EBITDA and debt service looked great! Thus, underlining the importance of free cash flow and knowing a company’s working capital requirements.
Barry,
I respectfully disagree that the UCA coverage ratio be included in loan documents. Unfortunately, company financial officers can manipulate the inputs to UCA cash flow to the detriment of a lender. Moreover, even a ‘conforming’ coverage ratio, when measured via the UCA cash flow, can give a lender a false sense of security. For example, an increase in accounts payable is recorded as a source of cash in the UCA cash flow even if that source isn’t recurring. If you are attempting to evaluate a company’s cash flow generating ability for servicing long term debt, you may be lulled into thinking the firm can look to that source of cash on a continuing basis.
In my opinion, measuring a company’s cash flow generating ability through traditional measures (EBITDA-maintenance capex)/(Total Debt Service) will prove more accurate, and more enforceable, when considering loan documentation.
Bill makes a great point and I would like to add on to that to include the use of a Limitation on CapEx, Dividends and Officer Compensation Covenants. This helps keep the profits in the company required to maintain or improve upon the financial condition of the company as exhibited at approval. Often we approve a loan with favorable rates and terms.
Bill,
I think I’m going to respectfully agree and disagree with you on this one. In operating companies the uCA is the best method, but it can be manipulated, though EBITDA can as well by simply pushing off an expense at month, quarter, year end.
I like using AR and AP and inventory covenants. For example, keep inventory turns below or above X, keep payable days above or below Y.
Just a thought!
Good discussion. You all have hit on the main point, the balance sheet and income statement work together. A good covenant package will take this into account. UCA is great analytical tool, but like Bill I think it has issues as a covenant (in my mind the issue is mostly practical – it’s too complex for most small business borrowers). I too like EBITDA less maintenance cap x / total debt service as the base coverage ratio. True, it can be “gamed” by the savvy CFO, but this can be limited by employing other measures that take liquidity and capital into account. For these I always use a relative and an absolute measure, i.e. current ratio and minimum net working capital for liquidity and D/TNW and minimum equity for capital. The key is to craft these as a package and test them through projections to know what causes one to “break”.
A few points to add:
– EBITDA is not based on accounting standards (unlike NPAT) and is therefore often defined by ‘market standard’ (which changes) as opposed to a more independent, stable standard.
– Anyone who has ever negotiated how EBITDA is defined for LBO or restructuring purposes knows that the ‘accuracy/simplicity’ tradeoff with EBITDA very quickly dissipates. I have negotiated EBITDA definitions 2-3 pages long with various carveouts and cross-references. (Good luck to the portfolio guy who has to calculate it 3 years later.)
– Nothing beats understanding your borrower. E.g. no one should willingly use EBITDA coverage for a high-capex/high-growth business that burns through cash.
James,
Great suggestions. I particularly like the idea of using a ‘suite’ of ratios that measures cash flow, liquidity and capital simultaneously. It can also be helpful to allow the company to continuously measure its adherence to the covenants more frequently than stipulated in the loan agreement–i.e., suggest the company measure its compliance monthly, even if quarterly compliance is required. By doing so, a lender can help business management more effectively adjust its procedures as operating conditions change.
It’s better to have an early warning of a deteriorating trend than to be surprised with an out-of-compliance condition.
Its good to have a few different ratios but I would not go beyond 2 or 3 ratios and I would stay as clear as possible and as standard as possible. If you get too many or unclear or unusual ratios (even if you define them in your loan agreement) there is bound to be confusion and disagreements between borrower and lender.
Robert,
Excellent point. As an analyst by background, I have found that it’s all too easy to overload a loan agreement with excessive ratio measurement–in effect, virtually guaranteeing that the borrower will be out of compliance at some point in the future.
Focusing on a few key ratios for compliance is a far better loan management strategy. Not only will there be fewer opportunities for misinterpretations by either party.