“Understanding Customary Financial Covenants”		«BACK
	by Randy B. Evans
	from Restaurant Finance Monitor, March 2004 Issue

Senior debt, subordinated debt and mezzanine financing agreements generally include one or more financial covenants to enable the lender or investor to monitor the financial performance of the company on a periodic basis. The reason for this is that lenders and investors want to minimize their risk, but for liability and other reasons they do not want to be involved in controlling the day-to-day management of the company. Financial ratios and other financial requirements provide the lender or investor with an effective mechanism to monitor performance without being directly involved.

The following is a primer on a few of the financial covenants customarily included in financing agreements:

The following is a primer on a few of the financial covenants customarily included in financing agreements:

Pre-Compensation Fixed Charge Coverage Ratio

This ratio measures a company’s cash flow cushion and ability to pay its debt service and other fixed expenses, by comparing its Pre-Compensation Cash Flow (typically EBITDA minus any non-recurring income items) to its Fixed Charges (typically current portion of long term debt and capitalized leases, interest expense and third-party rent). Pre-Compensation FCCR is expressed as a minimum ratio (for example, 1.3 to 1.0). This means that the company’s Pre-Compensation Cash Flow must equal or exceed 1.3 times its Fixed Charges, typically measured quarterly on a rolling twelve month basis, in order to provide an acceptable cash flow cushion.

Post-Compensation Fixed Charge Coverage Ratio

This ratio is similar to Pre-Compensation FCCR, but measures a company’s cash flow cushion and ability to pay its debt service and other fixed expenses, by comparing its Post-Compensation Cash Flow (typically EBITDA minus any non-recurring income items and minus dividends, distributions, loan payments and other non-expensed compensation paid to owners and affiliates) to its Fixed Charges (typically current portion of long term debt and capitalized leases, interest expense and third-party rent). This ratio is generally used as a restriction on dividends and other forms of owner compensation. Post-Compensation FCCR is also expressed as a minimum ratio (for example, 1.1 to 1.0). This means that the company’s Post-Compensation Cash Flow must equal or exceed 1.1 times its Fixed Charges, typically measured quarterly on a rolling twelve month basis, in order to provide an acceptable cash flow cushion after owners’ compensation.
(Continued on reverse side)

Funded Debt to EBITDA

This ratio measures the amount of a company’s leverage, by comparing its Funded Debt (typically obligations for borrowed money, deferred purchase price of assets and capitalized leases) to the company’s EBITDA (earnings before interest, taxes, depreciation and amortization). Funded Debt to EBITDA is expressed as a maximum ratio (for example, 3.5 to 1.0). This means that the company’s Funded Debt may not exceed 3.5 times its EBITDA, typically measured quarterly on a rolling twelve month basis, in order to ensure an acceptable level of leverage.

Current Ratio

This ratio measures a company’s liquidity, by comparing its Current Assets (typically cash, non-related party accounts receivable and other current assets under GAAP) to its Current Liabilities (typically current liabilities under GAAP, excluding related party payables and current portion of long term debt and capitalized leases). Current Ratio is expressed as a minimum ratio (for example, 0.75 to 1.0). This means that the company’s Current Assets must equal or exceed seventy-five percent (75%) of its Current Liabilities, typically measured as of the last day of each fiscal or calendar quarter, in order to provide an acceptable level of liquidity.

Tangible Net Worth

This covenant requires a company to maintain a certain level of Tangible Net Worth, expressed as a minimum dollar amount (for example, $1,000,000), in order to ensure the continued financial strength of the company. Tangible Net Worth typically excludes goodwill and other intangible assets of the company, and is measured on an annual basis at the end of the company’s fiscal year.

Net Income

This covenant requires a company to maintain a certain level of Net Income, expressed as a minimum dollar amount (for example, $500,000). Net Income is typically measured on an annual basis at the end of the company’s fiscal year, and the covenant requirement may be as low as one dollar, simply to require that the company not show a net loss for the year.

The above-described financial covenants are customary and illustrative, but are not exhaustive and are often highly negotiated. In addition, most financing agreements also include additional affirmative, negative and financial covenants tailored specifically to the particular company or industry involved. It is important to understand the theory behind each covenant and what the lender or investor is hoping to achieve. Likewise, it is important to understand the terminology and the practical application of each financial covenant to your specific situation.