Recently I came across a loan agreement which included a Debt Service Cover Ratio (DSCR) as a maintenance financial covenant.<\/p>\n\n\n\n
While it is a common covenant in loan agreements<\/strong>, the threshold of 1,0x caught my attention immediately.<\/p>\n\n\n\n Please be reminded that the goal of a financial covenant is to provide an early warning sign (EWS) of credit deterioration to lenders.<\/strong><\/p>\n\n\n\n ________<\/p>\n\n\n\n There are two key issues in this case:<\/p>\n\n\n\n 1) The value of such low threshold is limited<\/strong><\/p>\n\n\n\n If a company from this case breaches the DSCR, it is likely already out of money.<\/strong><\/p>\n\n\n\n Why?<\/p>\n\n\n\n The covenant threshold of 1,0x means the company would breach the contract if the formula\u2019s numerator (however defined) would be below the scheduled loan repayments for the year.<\/p>\n\n\n\n Numerator for DSCR calculation is normally some form of cash flow.<\/p>\n\n\n\n If the company does not generate enough cash flow to service debt, it is likely out of cash.<\/p>\n\n\n\n Unless\u2026<\/p>\n\n\n\n Unless the company is cash rich.<\/p>\n\n\n\n But why would a cash rich (i.e., creditworthy) company accept exclusion of the available cash from the formula\u2019s numerator and risk the breach of the contract and all issues coming with the breach?<\/strong><\/p>\n\n\n\n (Spoiler alert: cash was not included in the numerator)<\/p>\n\n\n\n If the company was not creditworthy, why would the bank introduce such a low threshold? Which value would this covenant provide to the bank?<\/strong><\/p>\n\n\n\n 2) The DSCR definition<\/strong><\/p>\n\n\n\n We can increasingly see EBITDA as a numerator in the DSCR formula.<\/p>\n\n\n\n I am not a fan of such definition knowing what EBITDA really represents. (C. Munger coined a well-known definition ????)<\/p>\n\n\n\n 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.<\/strong><\/p>\n\n\n\n Such definition is completely useless for the bank.<\/p>\n\n\n\n ________<\/p>\n\n\n\n DSCR can be a very helpful EWS if defined properly.<\/strong><\/p>\n\n\n\n Otherwise, it is just a condition which can perhaps create even more damage to both sides.<\/strong><\/p>\n\n\n\n ________<\/p>\n\n\n\n CreditAnalyst(.eu) – Company Analyses | Negotiations with Banks | Cash Flow Planning<\/strong><\/p>\n","protected":false},"excerpt":{"rendered":" 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 [\u2026]<\/span><\/p>\n","protected":false},"author":4,"featured_media":0,"comment_status":"closed","ping_status":"closed","sticky":false,"template":"","format":"standard","meta":{"footnotes":""},"categories":[19,22],"tags":[133,47,55,123,59,172],"class_list":["post-1024","post","type-post","status-publish","format-standard","hentry","category-credit-guide-2","category-credit-insights","tag-cash-flow","tag-credit-analysis-2","tag-credit-risk","tag-ebitda-2","tag-financial-statements-analysis","tag-loan-agreement"],"_links":{"self":[{"href":"https:\/\/kurtovicfinancial.com\/en\/wp-json\/wp\/v2\/posts\/1024","targetHints":{"allow":["GET"]}}],"collection":[{"href":"https:\/\/kurtovicfinancial.com\/en\/wp-json\/wp\/v2\/posts"}],"about":[{"href":"https:\/\/kurtovicfinancial.com\/en\/wp-json\/wp\/v2\/types\/post"}],"author":[{"embeddable":true,"href":"https:\/\/kurtovicfinancial.com\/en\/wp-json\/wp\/v2\/users\/4"}],"replies":[{"embeddable":true,"href":"https:\/\/kurtovicfinancial.com\/en\/wp-json\/wp\/v2\/comments?post=1024"}],"version-history":[{"count":1,"href":"https:\/\/kurtovicfinancial.com\/en\/wp-json\/wp\/v2\/posts\/1024\/revisions"}],"predecessor-version":[{"id":1025,"href":"https:\/\/kurtovicfinancial.com\/en\/wp-json\/wp\/v2\/posts\/1024\/revisions\/1025"}],"wp:attachment":[{"href":"https:\/\/kurtovicfinancial.com\/en\/wp-json\/wp\/v2\/media?parent=1024"}],"wp:term":[{"taxonomy":"category","embeddable":true,"href":"https:\/\/kurtovicfinancial.com\/en\/wp-json\/wp\/v2\/categories?post=1024"},{"taxonomy":"post_tag","embeddable":true,"href":"https:\/\/kurtovicfinancial.com\/en\/wp-json\/wp\/v2\/tags?post=1024"}],"curies":[{"name":"wp","href":"https:\/\/api.w.org\/{rel}","templated":true}]}}