TOOL L4
Key Questions / Considerations
- Have the component parts of the ratios been defined correctly? (See separate tool). If not drawbacks are more severe than stated below
- Beware of generic descriptions like gearing, leverage and interest cover. There is no world-wide acceptance of the definition of these terms. Always check the precise definition
- Is the level of the covenant being stepped up?
- Is there a clear requirement for the client to show detailed calculations of the covenants in compliance documentation?
- None of these covenants is cash flow based so cannot be used to control Debt Service Capacity. This can only be done with cash flow covenants (see separate tool) which are only negotiable in high risk / leverage situations
- Consider whether the drawbacks can be compensated by additional clauses
| Covenant | Protection | Drawbacks |
| Minimum (Tangible) Net Worth | – Trading / extraordinary losses – Write down of assets – High provisions – Aggressive dividend policy exceeding profits – If tangible bank financed acquisitions – Back up to Net Worth / Total Assets ratio (see below) | – Does not control the level of external financing on or off balance sheet – Encourages the client to delay taking provisions – If Tangible, does not protect from impairment of intangible assets including goodwill (depending on accounting policy) |
| Net Worth / Total Assets | – As Minimum (T)NW – Controls capital structure and the length of the balance sheet and therefore protects against excessive growth. – Indirectly controls additional capex and debt. | – Default can be avoided by shrinking the size of the balance sheet unless the minimum (T)NW ratio is used as a back up – No account taken of off-balance sheet items unless included in the definition of Total Assets – No distinction between interest and non-interest bearing liabilities – Encourages the client to delay taking provisions – No control over matching of assets / liabilities |
| Debt / (Tangible) Net Worth | – As Minimum (T)NW – Controls the relative growth of Debt (interest bearing liabilities) and (T)NW and therefore indirectly protects against losses being financed by debt – Indirectly restricts activities of the company e.g. dividends, capex, acquisitions etc. when the company has no excess operating cash flow available | – Not control the length of the balance sheet or off balance sheet financing unless they are included in the definition of debt – No control over the term of debt – Debt priority position not protected – Take care of the US definition of Debt / Debt + (T) NW. Levels have to be set lower and the rate of change is more highly leveraged |
| Debt / EBITDA | – Controls that additional debt is used to add value to the business – Indirectly controls level of operating leasing as this reduces the EBITDA figure – By focusing on added value it removes the need to make a judgement on the quality of assets – Indirectly controls that sale proceeds of assets are used to reduce debt – Indirectly restricts activities of the company e.g. dividends, capex, acquisitions etc. when the company has no excess operating cash flow available | – Does not control capital structure or length of the Balance sheet – No control over the term of debt – Debt priority position not protected – Not practical for cyclical industries with volatile EBITDA – There can be a problem with time lags e.g. year end acquisitions – Take care of loose market practice to regard this as Debt Service capacity and use multiples as a guideline without considering definitions and type of industry carefully |
| EBIT(DA) / Gross (net) Interest and Capitalised Interest Interest coverage ratio (ICR) | – Controls that the company has sufficient margin in operating profit to cover increases in the cost of debt – Therefore protects profitability against increase of debt levels and/or volatility of interest rates – Triggers if there is a fall in profitability – Indirectly controls level of operating leasing as this reduces the EBITDA figure | – Gives no indication whether there is sufficient cash to pay interest – If using EBITDA in the definition make sure there is the appropriate increase in level set compared to using EBIT |
| Current Assets / Current Liabilities Current ratio | – Controls the matching of the tenor of all assets and liabilities – Indirectly protects against shortening debt maturity profile | – Easy to manipulate (see definition tool) especially with liquidity and quality of assets and the true term of long term liabilities – Mistaken view that >1 indicates liquidity |
