Credit metrics and covenants

Company loans are judged on cash flow, and the usual starting point is EBITDA: earnings before interest, taxes, depreciation and amortisation. It's a rough measure of the cash the business makes from operations before paying its lenders, the tax authorities and for wear and tear on its equipment.

Borrowers present adjusted EBITDA, adding back costs they say won't repeat: a lawsuit, a factory move, the costs of the deal itself, and sometimes savings they expect to make. Some add-backs are fair. Others aren't, and an aggressive list can make a company look much less borrowed than it is. Lenders check each one, often with a quality of earnings report from accountants, and give little or no credit for savings that haven't happened yet.

Leverage is total debt ÷ EBITDA: how many years of EBITDA the debt equals. Net leverage takes off cash first. Interest coverage is EBITDA ÷ cash interest. The fixed-charge coverage ratio (FCCR) is stricter: one common form is (EBITDA − capital spending − cash taxes) ÷ (interest + scheduled principal). Definitions vary from loan to loan, so the credit agreement's definitions are what count.

ebitda = 25_000_000
debt = 115_000_000
interest = 11_500_000
capex, taxes, principal = 4_000_000, 2_000_000, 1_150_000
print(f"leverage {debt / ebitda:.1f}x")
print(f"interest coverage {ebitda / interest:.2f}x")
fccr = (ebitda - capex - taxes) / (interest + principal)
print(f"fixed charge coverage {fccr:.2f}x")

Liquidity is the cash a company can reach: cash on hand plus what it can still draw on its revolving credit line. A profitable company can still fail if it runs out of cash, so lenders watch liquidity closely, especially in a downturn or a season of heavy spending.

Covenants are the loan's promises. Maintenance covenants are tested on a schedule, usually every quarter, whatever the company does: total leverage must stay below 5.5x, say. Incurrence covenants are tested only when the company wants to do something, such as borrow more, pay a dividend or buy another business, and only block that action. Many large, widely traded loans are covenant-lite (incurrence only); direct loans to mid-sized companies more often keep at least one maintenance covenant, which lets the lender sit down with the company early when results slip.

Cushion (or headroom) is how far EBITDA can fall before a covenant breaks. With $115m of debt and a 5.5x maximum, EBITDA can drop to about $20.9m from $25m, a cushion of about 16%. Lenders usually set covenants with a cushion of something like 25% to 35% from the starting figures, so ordinary bumps don't cause a breach.