We’ve been running a poll on the Comments on Credit blog for the past few months asking 2 questions:
It is no surprise that bankers like the debt service coverage and fixed charge coverage ratios best – they are good measures of a company’s ability to pay its financial obligations as they come due (without relying on external financing). We think they are the best ratios to measure a company’s liquidity (much better than the current and quick ratios, but that is a topic for another post).
If debt service coverage and fixed charge are the best measures of coverage (and liquidity), the real question is why we don’t use them more often in covenants? The most used coverage covenant (in our survey and in our experience) is EBITDA coverage.
Accuracy vs. Simplicity
Whenever we look at ratios, for analytical purposes or for covenants, there are always the conflicting goals of accuracy and simplicity. We could write a ratio that looks at a company’s internally generated cash flow (say, free cash flow) relative to all of its future, normalized financial and operating cash outflows, but by the time we write the definition into a credit agreement it would be too long and cumbersome. As it is, we’ve see fixed charge coverage definitions that exceed one full page of (very small) text. And even then, there may be disagreements between borrower and lender about how it should be calculated.
So, in order to make the numbers easy to calculate and avoid disputes in the future, we sometimes go with simpler covenants, even if they are not the best measures of a company’s risk. Thus, EBITDA coverage is used more often than debt service coverage.