Financial Covenants – Part III
Leverage Ratio Covenant
On each [Fiscal Quarter End Date], the Borrower shall ensure that the ratio of [Total Debt] to [EBITDA] for the most recently ended fiscal quarter does not at any time exceed [__]:1.00.
Who is it and what does it do?
The leverage ratio measures the extent to which a business utilizes debt to finance its assets and operations. On one hand, the use of debt can be beneficial to a business by amplifying profits, but on the other hand, excessive debt in the capital structure of a business can be risky because debt must be serviced on an ongoing basis and eventually repaid or refinanced.
A leverage ratio test can take different forms: the amount of debt may be measured against, to name a few examples, total assets, total equity or cash flows of the business. Each such measurement may have slightly different nuances, but the overarching goal of such test is for the lender to ensure that the amount of debt of a business does not rise to an unsustainable level. A default under a debt instrument can trigger actions by other creditors against the business, including a bankruptcy proceeding, which will negatively affect the lender’s ability to recover its debt. One of the most common leverage ratio tests seen in credit agreements (which will be the focus of this article) is the ratio of total debt to EBITDA (which is used as a proxy for the company’s operating cash flows).
Why is it there?
As is the case with many of the financial maintenance ratios, the leverage ratio test often acts as an early warning sign to lenders. The breach of the test in and of itself may not suggest that a borrower is in an immediate danger of defaulting on the loan or filing for bankruptcy, but it does give the lender a window into the borrower’s financial health. If the leverage ratio is trending higher and in excess of the pre-negotiated level, the lender may wish to bring the borrower to the table to re-negotiate or restructure its debt terms.
How is it negotiated and how is it relevant to shipping?
The language of the leverage ratio test as a legal matter is well-established. The test is very often performed on a quarterly basis, and sometimes, there is a temporally limited cure right (typically by the equity holder’s injection of capital to bolster the company’s cash flow).
On the denominator side of the ratio, the calculation of EBITDA for this purpose is the same as the method employed for the debt service coverage ratio discussed in the last installment of this series. The credit agreement will have a defined term “EBITDA” to be used throughout the document.
On the numerator side, the calculation of total debt comes with a few nuances. First, “debt” for this purpose is broadly defined and includes not only the money borrowed from another but also other types of financial obligations. A guarantee or indemnity obligation may be one example. A hedging obligation or redeemable share issuance could be another.
As it relates to shipping, of particular importance in the calculation of the debt amount is the recent change in GAAP dealing with the treatment of operating leases. While it is an accounting matter that needs to be determined by an accountant, an operating lease (for example, a time charter involving a vessel) may now need to be recognized as debt on the balance sheet, thereby included in the calculation of total debt (depending, of course, on the terms of the credit agreement).
Second, the calculation of total debt sometimes deducts the amount of unrestricted cash on hand held by the borrower or the relevant obligor group that is being measured. The idea is that a business could in theory apply the available cash to reduce the debt amount but should not be forced to do so just to meet the leverage ratio – there may be a good justification to hold on to the cash for business or operational reasons.
Third, the total debt amount may be determined on a consolidated group-wide level, which may include subsidiaries that are not obligors to the credit facility. The notion is that an unsustainable level of debt on a consolidated basis may affect the quality of the parent’s guaranty of the debt. The inclusion of non-obligor subsidiaries in the total debt calculation indirectly restricts their ability to incur debt. This may be of relevance to shipping companies where siloed SPV-level financings are common. If there is a leverage test measured at the parent level on a consolidated basis, a subsidiary SPV may need to be mindful of that restriction before it can incur debt (or refinance with cash out).