Financial Covenants – Part II
Debt Service Coverage Ratio Covenant
On each [Fiscal Quarter End Date], the Borrower shall ensure that the Debt Service Coverage Ratio for the most recently ended [fiscal quarter] is at least [__]:1.00.
“Debt Service Coverage Ratio” means, for any period, the ratio of
(a) the [EBITDA or Earnings Before Interest Taxes Depreciation and Amortization] of the Borrower for such period
(b) the [Debt Service] of the Borrower for such period
Who is it and what does it do?
The debt service coverage ratio covenant (sometimes referred to as the “DSCR” covenant) measures the borrower’s ability to pay its then current debt service obligations. A DSCR that is greater than 1.0 indicates that the borrower’s business has generated sufficient cash flows to cover its debt service. A similar concept sometimes appears in a loan agreement by way of a fixed charge coverage ratio or interest coverage ratio – the notion remains that a borrower should be able to service its regularly scheduled financial obligations (with some amount of cushion), and the lender needs to know if that ability has been impaired.
Why is it there?
The DSCR is an indicator of the financial health of the borrower by measuring cash flow. A DSCR less than 1.0 suggests that the borrower’s operations are not able to satisfy its regularly scheduled debt payments. In these situations, the borrower may need to sell assets to shore up its cash position or raise additional capital, or both. The DSCR covenant can serve as a useful mechanism through which the lender can bring the borrower to the table to re-negotiate or restructure the debt terms.
How is it negotiated and how is it relevant to shipping?
The language of the DSCR 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 borrower’s cash flow).
As a commercial matter, what is included in the calculation of the cash flows of the borrower (which comprises the numerator of the ratio) is a point of negotiation. Often, lenders use the concept of EBITDA as a proxy for the borrower’s cash flows. Depending on the context, the definition of EBITDA (more specifically, the “add backs” that may increase the EBITDA amount) may be heavily negotiated. The calculation typically starts with the borrower’s “net income” (as calculated under GAAP or other accounting principles) but attempts to derive a normalized picture of the borrower’s operations by excluding the effects of one-off items; hence, the definition of EBITDA in a loan agreement generally excludes extraordinary items and sometimes adds back certain charges and expenses incurred that are of a transient nature.
On the denominator side of the ratio, the debt service amount typically includes the aggregate interest expense and repayment installments payable by the borrower and is often not controversial in an SPV borrower structure (as the SPV borrower does not (and will not) have other debt obligations). Where the concept becomes more complex is in corporate-level and multi-vessel financings. In such a financing structure, it is imperative that the lender identify what other debt or debt-like obligations the obligor group must service on a regular basis. This may include, for example, lease or charter hire payments if chartered-in vessels are involved in the obligor group.
Finally, how much of a buffer the lender will require in the borrower’s cash flows above the borrower’s debt service amount is a matter of commercial negotiation, but a ratio of 1.1-1.3 is not uncommon.