The above-described financial covenants are customary
and illustrative, but are not exhaustive and are often
highly negotiated. Financing arrangements also customarily
include additional affirmative, negative and
financial covenants tailored specifically
to the particular company or industry involved.
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FINANCIAL COVENANTS
A PRIMER ON CUSTOMARY FINANCIAL COVENANTS
FOR SENIOR DEBT, SUBORDINATED DEBT AND
MEZZANINE FINANCING ARRANGEMENTS
Premise: Lenders and investors desire to minimize their risk without controlling
day to day management of the company. Therefore, financing arrangements
customarily include one or more financial covenants to enable the lender or
investor to monitor the financial performance of the company on a periodic
basis. Some customary financial covenants include the following:
Pre-Compensation
FCCR
Post-Compensation
FCCR
Funded Debt/
EBITDA
Effective Funded
Debt to EBITDAR
Current
Ratio
Net
Income
PRE-COMPENSATION FIXED CHARGE COVERAGE RATIO (Cash Flow)
This ratio measures a company’s cash flow cushion and ability to pay its debt
service and other fixed expenses, by comparing its Pre-Compensation Cash Flow
(typically EBITDA minus any non-recurring income items) to its Fixed Charges
(typically current portion of long term debt and capitalized leases, interest expense
and third-party rent). Pre-Compensation FCCR is expressed as a minimum ratio (for
example, 1.3 to 1.0). This means that the company’s Pre-Compensation Cash Flow
must equal or exceed 1.3 times its Fixed Charges, typically measured quarterly on a
rolling twelve month basis, in order to provide an acceptable cash flow cushion.
POST-COMPENSATION FIXED CHARGE COVERAGE RATIO (Cash Flow)
This ratio is similar to Pre-Compensation FCCR, but measures a company’s cash flow
cushion and ability to pay its debt service and other fixed expenses, by comparing its
Post-Compensation Cash Flow (typically EBITDA minus any non-recurring income
items and minus dividends, distributions, loan payments and other non-expensed
compensation paid to owners and affiliates) to its Fixed Charges (typically current
portion of long term debt and capitalized leases, interest expense and third-party rent).
This ratio is generally used as a restriction on dividends and other forms of owner
compensation. Post-Compensation FCCR is also expressed as a minimum ratio (for
example, 1.1 to 1.0). This means that the company’s Post-Compensation Cash Flow
must equal or exceed 1.1 times its Fixed Charges, typically measured quarterly on a
rolling twelve month basis, in order to provide an acceptable cash flow cushion after
owner’s compensation.
FUNDED DEBT TO EBITDA (Leverage)
This ratio measures the amount of a company’s leverage, by comparing its Funded
Debt (typically obligations for borrowed money, deferred purchase price of assets
and capitalized leases) to the company’s EBITDA (earnings before interest, taxes,
depreciation and amortization). Funded Debt to EBITDA is expressed as a
maximum ratio (for example, 3.5 to 1.0). This means that the company’s Funded
Debt may not exceed 3.5 times its EBITDA, typically measured quarterly on a rolling
twelve month basis, in order to ensure an acceptable level of leverage.
EFFECTIVE FUNDED DEBT TO EBITDAR (Effective Leverage)
This ratio measures the amount of a company’s leverage, by comparing its Effective
Funded Debt (typically obligations for borrowed money, deferred purchase price of
assets, capitalized leases and an amount equal to annual rent on operating leases
multiplied by 8) to the company’s EBITDAR (EBITDA plus annual rent). It is
expressed as a maximum ratio (for example, 5.0 to 1.0). This means that the
company’s Effective Funded Debt may not exceed 5.0 times its EBITDAR, typically
measured quarterly on a rolling twelve month basis, in order to ensure an
acceptable level of leverage, including rental obligations.
CURRENT RATIO (Liquidity)
This ratio measures a company’s liquidity, by comparing its Current Assets (typically
cash, non-related party accounts receivable and other current assets under GAAP)
to its Current Liabilities (typically current liabilities under GAAP, excluding related
party payables and current portion of long term debt and capitalized leases).
Current Ratio is expressed as a minimum ratio (for example, 1.0 to 1.0). This means
that the company’s Current Assets must equal or exceed its Current Liabilities,
typically measured as of the last day of each fiscal or calendar quarter, in order to
provide an acceptable level of liquidity.
NET INCOME (Profitability)
This covenant requires a company to maintain a certain level of Net Income,
expressed as a minimum dollar amount (for example, $500,000). Net Income is
typically measured on an annual basis at the end of the company’s fiscal year, and the
covenant requirement may be as low as one dollar, simply to require that the
company not show a net loss for the year.