HOW FINANCIAL STATEMENTS ANALYSIS SOLVES YOUR PROBLEMS – real-life examples
25. May 2023.DIVIDEND PAYOUT LIMITATIONS – HOW TO NEGOTIATE THE CLAUSE AND FIND A MIDDLE GROUND
6. July 2023.ICR is often used as a financial covenant in loan documentation. Sometimes as a part of a wider fin. covenant package, but sometimes also as the only fin. covenant in place.
In the latter cases, lenders risk having an ineffective covenant in place due to these most common issues with ICR:
1 Low interest rate environment
Although interest rates have gone up recently, there are still many legacy deals with fixed interest rates. Unless a company had a terrible performance resulting in very low or negative EBITDA, the covenant will most likely not be triggered.
However, this issue will disappear now that interest rates have gone up significantly.
2 Amortizing loans
The purpose of the ICR in amortising loans is questionable, because if a company cannot service its debt, it will most likely miss both interest and principal repayment in the future. The ICR could miss telling lenders the company is in trouble just because the EBITDA was high enough to cover the interest expense. The covenant works better in bullet structures, where a refinancing is envisaged and expected.
3 High margin businesses
Another context which the ICR does not work well in, are the high margin businesses. For example, if a company normally has an EBITDA margin of 40-50%, a drop in the margin to 25-30% would be a huge deterioration. However, the ICR might not be triggered, because interest expenses rarely amount to 15-20% of sales. So, if you have an ICR of 3x as a threshold and interest expenses making 8% of sales, with EBITDA margin of 30% it would still not be triggered.
4 ICR formula
Most often the numerator includes EBITDA. There were numerous articles written here on Linkedin about pitfalls of EBITDA as a metric. EBITDA ignores many things, most notably the elements affecting company’s cash flow, and we know that debt is repaid from cash, not from profits.
There are other versions of the ICR which take into account EBIT or operating cash flow, and they might be better solutions in some cases.
5 Threshold
The threshold has to be reasonable, and lenders cannot expect borrowers to accept the ICR of 10x. Many companies navigate successfully even with the ICRs of 4x. So, setting a covenant level at 2-3x seems more reasonable, yet meaningless for many companies, because once they reach that level they are already in default.
Defining proper financial covenants requires full understanding of the company’s business, the wider context, and the mechanics of the covenant (formula, definitions, threshold). Otherwise, lenders risk having ineffective protection in place.
On the other hand, borrowers (companies) need to understand all of this too in order to extract the highest possible value for them and minimise the risk of breaching a contract.
