## 4. Example of debt covenants

Let’s look at a simple example. Let’s assume that in 20X2 Borrower Company (a fictitious entity) entered into a debt agreement with Lender Bank (a fictitious entity). The debt agreement specified the following debt covenants, among others:

• The borrower must maintain the minimum interest coverage ratio of 3.20, based on the cash flow from operations.
• The borrower must maintain the minimum fixed charge coverage ratio of 2.50, based on the cash flow from operations.
• The borrower cannot pay annual cash dividends exceeding 50% of net earnings.
• The company cannot increase salaries of its executive officers.

As we can see, the debt agreement includes performance covenants, along with some negative debt covenants. Interest coverage and fixed-charge coverage ratios indicate whether the company can meet its interest expense and fixed commitments, accordingly, from its earnings or cash flow from operations.

Interest coverage ratio can be computed in two ways:

1. Income Before Taxes And Interest ÷ Interest Expense
2. Cash Flow from Operations and Interest ÷ Interest Expense

The interest coverage ratio shows the number of times interest expense can be covered by income before taxes or cash flow from operations. It is better to base the interest coverage ratio on the cash flow from operations (i.e., actual cash). Usually management and creditors look at the interest coverage ratio trend over time to assess the interest-bearing debt burden the company can handle.

The following information was used to calculate the interest coverage ratio of Borrower Company:

 20X1 20X0 20X9 (A) Income before taxes 120,000 100,000 95,000 (B) Cash flow from operations 72,000 70,000 60,000 (C) Interest expense 32,000 25,000 20,000 [(A)+(C)] ÷ (C) Interest coverage based on earnings 4.75 5.00 5.75 [(B)+(C)] ÷ (C) Interest coverage based on cash flow from operations 3.25 3.80 4.00

In 20X1, there was \$4.75 in income before taxes and \$3.25 in cash earnings to cover interest expense. By looking at the trend, we can see that the interest coverage ratio of the company decreased in the past three (3) years. Such a decrease in the interest coverage ratio could be a concern for the lender.

Fixed-charge coverage ratio can be computed in many ways. For example:

1. Income before Taxes and Fixed Charges ÷ Fixed Charges
2. Cash Flow from Operations and Fixed Charges ÷ Fixed Charges
3. Income before Taxes Adjusted for Capitalized Interest ÷ Fixed Charges Adjusted for Capitalized Interest
4. Income before Taxes Adjusted for Capitalized Interest and Operating Leases ÷ Fixed Charges Adjusted for Capitalized Interest and Operating Leases

The following information was used to calculate the fixed-charge coverage ratio of Borrower Company:

 20X1 20X0 20X9 (A) Income before taxes 120,000 100,000 95,000 (B) Cash flow from operations 72,000 70,000 60,000 (C) Fixed charges 46,000 38,000 32,000 [(A)+(C)] ÷ (C) Fixed-charge coverage based on earnings 3.61 3.63 3.97 [(B)+(C)] ÷ (C) Fixed-charge coverage based on cash flow from operations 2.57 2.84 2.88

As we can see from the table above, in 20X1 there was \$3.61 in income before taxes and \$2.57 in cash flow from operations for each \$1 in fixed charges. The low ratio indicates a higher risk for the lender because the company might not be able to meet its fixed charge commitments if the business activity decreases.

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