EBITDA Interest cover vs EBIT Interest cover – which one is better?
11. kolovoza 2023.EBITDA definition in theory and practice – When to pay special attention
16. kolovoza 2023.Recently I came across a loan agreement which included a Debt Service Cover Ratio (DSCR) as a maintenance financial covenant.
While it is a common covenant in loan agreements, the threshold of 1,0x caught my attention immediately.
Please be reminded that the goal of a financial covenant is to provide an early warning sign (EWS) of credit deterioration to lenders.
________
There are two key issues in this case:
1) The value of such low threshold is limited
If a company from this case breaches the DSCR, it is likely already out of money.
Why?
The covenant threshold of 1,0x means the company would breach the contract if the formula’s numerator (however defined) would be below the scheduled loan repayments for the year.
Numerator for DSCR calculation is normally some form of cash flow.
If the company does not generate enough cash flow to service debt, it is likely out of cash.
Unless…
Unless the company is cash rich.
But why would a cash rich (i.e., creditworthy) company accept exclusion of the available cash from the formula’s numerator and risk the breach of the contract and all issues coming with the breach?
(Spoiler alert: cash was not included in the numerator)
If the company was not creditworthy, why would the bank introduce such a low threshold? Which value would this covenant provide to the bank?
2) The DSCR definition
We can increasingly see EBITDA as a numerator in the DSCR formula.
I am not a fan of such definition knowing what EBITDA really represents. (C. Munger coined a well-known definition ????)
The combination of EBITDA as a numerator and a threshold of 1,0x means that the real threshold is significantly below 1,0x as the EBITDA formula omits important cash outflows such as taxes, Capex, and working capital.
Such definition is completely useless for the bank.
________
DSCR can be a very helpful EWS if defined properly.
Otherwise, it is just a condition which can perhaps create even more damage to both sides.
________
CreditAnalyst(.eu) – Company Analyses | Negotiations with Banks | Cash Flow Planning