The importance of financial covenants for the long-term success of a borrower-lender relationship cannot be overstated. In this multi-part blog post series, we will review the key negotiating levers for the most common financial covenants included in middle market cash flow loan (C&I loan) transactions. Part two will focus on leverage ratio covenants. Subsequent blog posts will provide a detailed review of other common financial covenants including the fixed charge coverage ratio, the minimum liquidity covenant, the minimum EBITDA covenant, and the minimum recurring revenue covenant.
Financial Covenants Generally
Few issues elicit the level of negotiation in credit agreements that financial covenants do. Financial covenants come in many varieties and are typically tied to one or more financial metrics of the borrower including cash flow, leverage, liquidity and/or net worth.
These financial metrics are designed to:
- Allow a lender to monitor changes in a borrower’s financial performance,
- limit a borrower’s ability to take certain actions,
- provide an early warning of potential financial hardship, and
- provide a means of imposing financial discipline on the borrower.
From the borrower’s perspective, financial covenants allow access to credit that would only be available to the largest and most creditworthy firms without the added protection provided by financial covenants. As such, negotiating the correct scope and limitations of financial covenants can have major implications on the long-term success of the borrower-lender relationship.
The scope of financial covenants included in a given credit agreement is a function of:
- market conditions,
- a particular borrower’s financial health (i.e., stability and predictability of cash flows),
- the nature of the borrower’s business, and
- the negotiating strength of the respective parties.
Below is a brief description of certain types of common financial covenants that often appear in credit agreements.
Maximum Leverage Ratio
The leverage ratio is the most common financial covenant metric used in credit agreements. The leverage ratio is calculated as total indebtedness divided by earnings before interest, taxes, depreciation and amortization (i.e., EBITDA) or earnings before interest, taxes, depreciation, amortization and rent(i.e., EBITDAR) and provides an indication of how the borrower’s assets and business operations are financed. High levels of leverage can be risky for lenders because they adversely affect a borrower’s ability to respond to declining profitability stemming from market headwinds or any other reason. To address this risk, the leverage ratio covenant in credit agreements sets a ceiling on the borrower’s total leverage based on the risk appetite and negotiating strength of the parties. In some credit agreements, the leverage ratio is calculated using only senior indebtedness which narrows the lenders’ focus to debt with a first priority lien versus total indebtedness.
Minimum Fixed Charge Coverage Ratio
In addition to the leverage ratio, the fixed charge coverage ratio is a frequent component of financial covenants in credit agreements. The fixed charge coverage ratio is commonly calculated as adjusted EBITDA divided by fixed charges (i.e., charges that remain constant irrespective of sales such as interest expense, insurance payments, etc.) and measures a borrower’s ability to generate operating cash flow sufficient to service the needs of the company. Similarly, the interest coverage ratio, which measures the borrower’s ability to service interest expense, as opposed to total fixed charges, with operating cash flows is a common variant of the fixed charge coverage ratio. Coverage ratio covenants set a floor for the borrower to ensure a minimum level of cash flow is maintained relative to certain key expenses like interest expense and fixed charge expenses.
Financial Covenants in Practice
In practice, the acceptable range of financial covenants are determined by the underlying definitions set forth in the credit agreement by including and excluding certain financial statement line items. If the borrower goes outside this negotiated range, the borrower is in default and the lender may declare an event of default. Once a default is triggered and/or an event of default is declared, the lender has certain remedial rights including accelerating the loan, requesting additional collateral and/or imposing additional fees. These protective tools allow the lender to monitor the health of the business and mitigate the risk of nonpayment.
In Part II …
In our next blog post, we will take a deeper dive into the maximum leverage coverage ratio and related definitions. Stay tuned…