A “positive covenant” in a loan agreement or bond is a requirement for the borrower to do something in a certain amount of time, such as submit financial reports. One such positive covenant is known as a Fixed Charge Coverage Ratio (FCCR). (Note that the name of this ratio may be slightly different from loan document to loan document.)
The FCCR requires the debtor to keep its finances above a certain threshold or number. As explained below,
this ratio is a measure of how much cash flow there is to cover fixed charges, typically payments to lenders.
A typical measure is Earnings Before Interest and Taxes, plus Depreciation and Amortization (EBITDA), less cash paid for non-financed capital expenditures, less cash distributed to owners for taxes, all divided by the total of all interest payments and principal payments. Sometimes, lease payments are included in the denominator, particularly for retailers with leased real estate and/or businesses with lots of equipment financed by leases.
In short, FCCR is an accounting definition of cash flow divided by total financing payments. Typically, lenders require this ratio be met on an annual basis for the fiscal year.
Note that this example is for a pass-through entity, such as an S-Corp or LLC, where the tax liability is “passed through” to the owners and the loan probably restricts distributions to owners other than for taxes and salaries. The wording of the FCCR will change a bit for different tax and legal structures. There is also a slightly different definition of FCCR used by financial analysts doing standardized ratio analysis of financial statements.
Why does the FCCR matter? Lenders want this covenant so they can take action if a company’s financial situation changes in a way that the risk of default becomes higher than was bargained for when the money was loaned.
If you are a business owner, you want to keep an eye on this ratio;
a reduction is a warning that your company’s financial situation has deteriorated.
What is a “good” FCCR? Small business lenders typically want a ratio higher than 1.2. Larger loans and investment grade bonds often want a much higher number. Leveraged loans and junk bonds typically don’t have this type of covenant. In fact, these days, leveraged loans and junk bonds have very few covenants, FCCR or otherwise. (My industry hopes this is a big mistake!)
A critical observation
Your company can borrow the same amount, but, with different types of loans have different FCCR ratios. How? By lowering the principal payments. This can be accomplished with interest-only payments or, if the lender insists on principal payments along the way, increasing the loan term (payments are lower on a 30-year residential mortgage than on a 15-year residential mortgage).
From a practical perspective,
this can be a done by financing current assets (think accounts receivables and inventory) with as much interest-only debt as you can arrange (e.g., revolvers and credit lines). Note that for these types of loans, payments that lower the loan balance from time to time are not included in the FCCR. Finance fixed assets with a term as long as the expected life of that asset. That said, lenders won’t finance 100% of your current assets, and the term of your fixed debt will be shorter than the expected life of the assets the fixed term debt finances.
one company I met with recently was turned down for a credit line increase by its bank. The credit line was a small fraction of the company’s accounts receivables, but the company was told that its FCCR was too low (around 1.05). The company has two problems. First, it needs to improve profitability so there is more EBITDA to cover debt service. Second, its bank “termed” some of its debt. That is, instead of a credit line that has interest-only payments, the loan is amortized like a residential mortgage over time with principal and interest payments. For this company, the loan was amortized over only 3 years. So the company went from no principal payments to high principal payments (because of the short term). This company has the wrong lender and wrong debt structure.
So what does all this mean? Finance current assets with a line of credit or revolver (a loan amount based on how much of those assets you have). Those payments are interest only. Finance fixed assets with debt (even if camouflaged as a lease), with a term a bit shorter than the assets expected useful life.
A few pointers
- Project your financials and calculate the FCCR when you do. You need to “see” what is in front of you so you can anticipate problems and take corrective action in advance. Lenders would much rather hear there might be a covenant problem before it happens; being blindsided by negative surprises always reduces the confidence others have in your business and your leadership of it. And don’t just project FCCR, look at other ratios that measure financial health, too.
- Project the FCCR and other ratios over different economic, company growth and industry scenarios. What looks good on paper today might not if your underlying assumptions about the future don’t materialize.
- Make sure your lender is comfortable lending against your assets and capital needs. Some lenders want the credit line to go to zero at some point during the year. If it doesn’t, they want to “term out your debt.” That’s a bad idea; look for a lender that won’t require this.
- Finance long term assets over their expected life. Certainly, no more than that. But not much shorter either.
A business’s Fixed Charge Coverage Ratio is an important measure. Use the concept to calculate the best capital structure for your business. Then monitor this ratio to keep a close eye on its financial health.