Financial covenant series

Cashflow available for debt service (sometimes cash available for debt service, abbreviated to either “CFADS” or “CADS”) is used in most cashflow based covenant calculations, such as DSCR, ICR, LLCR and PLCR. It seeks to measure the true ability of a business to repay its debts, whether in the one period or over time, without any influence of accrual accounting “tricks” or manipulations.

Current and quick ratios are indicators of a company’s immediate liquidity and its ability to pay its short term liabilities (such as accounts payable and short term debt) through using only its current assets (cash, accounts receivable, inventory). The difference between the two ratios is that “quick” only includes the most liquid assets in the calculation (which usually means excluding inventories).

Whether senior or total debt (senior + subordinated/mezzanine) debt is used for covenants will depend on the financial structure of the borrower and which lender you are talking about. Subordinated/mezzanine lenders, if they have financial covenants at all, are most likely to be interested in total debt, plus potentially having a senior debt covenant if senior lenders have one. Senior lenders will usually be most interested in senior debt ratios, but this depends on how deeply subordinated the other lenders are (such as through the subordinated debt being structurally subordinated through being loaned to a parent company rather than the same entity as the senior debt). If the subordinated lenders have no ability to accelerate their debt repayments or trigger an insolvency event and little ability to enforce any security, then there is little risk for senior lenders in having additional subordinated debt and so they are more likely to rely solely on senior debt covenants.

A number of the covenants we have looked at can be calculated on either a net or gross basis, such as Debt / EBITDA, DSCR, ICR, LLCR and PLCR.

Net debt

Most leveraged finance transactions seem to use a net debt definition in the covenants. Any cash on hand or in bank accounts (sometimes inclusive of short-term investments) is deducted from the gross debt balance on the basis that the cash could readily be used to immediately repay debt, rather than being wholly reliant on continued earnings.

A debt service reserve account (“DSRA”) is a special purpose bank account set up to provide additional security and is usually only contained in project finance transactions. Borrowers are required to maintain a minimum target balance within the account, with the target balance usually set as a fixed number of months of debt servicing costs (commonly 3, 6 or 12 months). As the target balance is based on projected costs (i.e. costs in future periods), the modelling of DSRAs can result in circular references. Borrowers can usually only withdraw money from the DSRA if funds are required to meet their debt obligations (i.e. DSCR is less than 1), or if the actual balance of the account is greater than the target balance.

Dealing with circular references

You actually have quite a few approaches to dealing with circular references in a DSRA. For more detail, see our article on Circular references and breaking them.

1. Ignore them – just let Excel iterate until it (hopefully) finds a stable solution for the model.
2. Put in a copy/paste macro – if the only circular reference you have in the model is from the DSRA, this will usually work (although does add calculation time, sometimes significantly).

The debt service cover ratio, or DSCR, is a measure of how easily a business or project can make its debt repayments. It is the ratio of the cashflow available for debt service (or “CFADS”) to the amount of debt service (principal repayments plus interest). A higher number is obviously better, both for you and the bank. It may be used to measure ongoing performance, or it might be used to determine the maximum amount of debt that a lender will advance.

The interest cover ratio, or ICR, is a measure of how easily a business or project can make it interest payments on its debt. There are at least two different versions of the ICR, one based on cashflow and one based on profit.

Cashflow ratio

The cashflow based calculation of ICR is nearly always used in project finance transactions, but can also be found elsewhere. It is the ratio of the cashflow available for debt service (or “CFADS”) to the amount of interest paid. It is almost identical to the DSCR calculation, except that principal repayments are not included in the denominator.

The aim of the loan life cover ratio (“LLCR”) is to measure how easily a loan can be repaid over the full life of the loan, rather than just in one period (such as with a DSCR). It is very common in project finance, but may also be used in leveraged finance or corporate transactions. At its simplest, the formula is:

 LLCR = NPV of CFADS / Debt principal outstanding

Depending on how loan repayments are scheduled, and how steady the cashflow is, the LLCR may be very close to the average DSCR.

The Project Life Cover Ratio (“PLCR”) looks at how much cash a project will generate over its full life compared to its debt balance. Its calculation is almost identical to the Loan life cover ratio except that all CFADS amounts are included rather than just for the life of the loan.

The Fixed Charge Cover Ratio (“FCCR”) is very similar to an ICR except that certain fixed expenses are shifted from above the line to below the line. The typical representation is

EBITDAR / (interest + rent)