In a control private equity transaction, debt is commonly employed to acquire a business. This debt creates obligations of interest and principal payments that are due on a timely basis. If these payments are not made creditors can take action to recover the sums borrowed by the company.
For this reason much of the financial analysis involved in underwriting a transaction will focus on the company’s ability to make timely interest and principal payments. The degree to which a company’s performance can decline while maintaining its debt obligations is an indication of safety. For example, if a company can continue to meet its debt obligations even if revenue declines by as much as 25% it might make investors more confident.
To measure this flexibility, a company will be modeled under various scenarios with debt ratios for each projected period. This permits evaluating the business under a variety of different capital structures. On a most superficial basis, debt ratio analysis revolves around a comparison of liquidity or measure of profitability and the debt-related obligations of a company. The simplest approach is to look at the amount of cash a company has on hand relative to the total debt. By subtracting cash from total debt on the balance sheet you arrive at Net Debt.
The more stable and consistent a company’s earnings, the more likely you are to feel comfortable with a large net debt balance. If a company’s earnings history is volatile, you will likely want to identify a capital structure that allows you to pay down debt quickly. Overall the objective should be to have your cash position grow relative to the amount of debt on the balance sheet. If a company’s net debt position is negative, then you know that you can most likely meet all debt obligations immediately (because you have more cash than debt).
From this point forward the ratios mentioned are likely to be found in credit term sheets and credit agreements. In addition to the items listed, it is not uncommon for creditors to require that a company maintain minimum levels of liquidity and EBITDA.
Moving beyond cash on the balance sheet, the most frequently used measure of profitability is EBITDA (Earnings Before Interest Taxes Depreciation and Amortization). The ratio of a company’s EBITDA in any period compared against the total sum of debt on the balance sheet is known as the debt-to-EBITDA ratio.
EBITDA provides a proxy for cash flow that facilitates back-of-the-envelope calculations surrounding the amount of leverage a company can comfortably assume. For example, if you knew that a company’s total-debt-to-EBITDA ratio was 2.0x you would likely comfortably assume that the company can easily meet its debt obligations. But if you saw that a company’s total-debt-to-EBITDA ratio was 5.0x it might be reason for concern. Absent some additional information, you really do not have a way to gauge if the company’s capital structure is appropriate.
Consider for example, that you are comparing leverage ratios for a SAAS business and an asset-heavy transportation business. The former would likely have minimal capital expenditures, but it would not be uncommon if the asset-heavy transportation business had capital expenditures equivalent to roughly 50% of EBITDA. These are very different cash needs, and the discrepancy highlights the need to go beyond back-of-the-envelope math.
For some additional precision, most credit agreements will include at least two financial covenants: (1) a measure of debt to EBITDA, and (2) the Fixed Charge Coverage Ratio.
Fixed Charge Coverage Ratio
The fixed charge coverage ratio is used to measure a company's ability to cover its "fixed charges" (largely debt-related payments but this can include additional obligations as you will see below) due in any given period. Below we will start with a simple visual and expand on this by including the definition a senior lender might use in a term sheet.
Formula from the image above:
( EBITDA – Capital Expenditures – Cash Taxes ) / ( Cash Interest Expense + Scheduled Debt Amortization )
The Fixed Charge Coverage Ratio gets more precise by subtracting additional uses of cash from EBITDA to get to a closer approximation of cash flow for the period. The logic behind subtracting capital expenditures instead of depreciation and amortization (the “DA” in EBITDA) is that capital expenditures are a cash outflow whereas D&A are noncash items. After that, cash taxes are subtracted to arrive at a better approximation of cash flow. Interest expense is not subtracted, but it can be found in the denominator (interest expense is one of the "fixed charges").
To elaborate on the denominator, rather than reference gross debt, this calculation looks at the actual cash required to remain in compliance in each period. Since you are more closely comparing the cash available for debt payments to the debt payments required in each period, a lender typically requires that this ratio remain above a minimum threshold of 1.2x.
Example of what you might find in a senior debt term sheet:
"Fixed Charge Coverage Ratio - Borrower shall not permit the ratio of (a) EBITDA minus the sum of (i) capital expenditures (excluding financed or equity funded capital expenditures), (ii) taxes, (iii) distributions, divided by (b) the sum of (i) cash interest expense and (ii) scheduled principal payments on total funded debt (including capital lease payments) to be less than 1.25x."
Notes on FCCR:
- It is not uncommon to see capital expenditures described as “unfunded capital expenditures” in the credit agreement. If capital expenditures are “funded” it suggests that additional debt was used to purchase the equipment. The debt raised offsets the cash outflow, and the interest and principal payments associated with this new debt end up in the denominator.
- Mandatory Debt Repayment might also be referred to as Scheduled Debt Amortization. The purpose is to include only the scheduled principal payments described in the credit agreement. Any optional repayment of debt would be excluded as would any repayment of debt under a cash flow sweep.
- Finally, lease payments might also be included in the denominator with cash interest expense and debt repayment.