# 11. Key Metrics for Covenants

Overview

Loan covenants often contain specific ratios that a company must abide by. Find out how to calculate these ratios in this lesson.

Summary

1. Lesson Goal (00:04)

The goal of this lesson is to calculate various metrics analyzing MarkerCo’s ability to make their debt repayments.

2. Calculating Net Debt (00:29)

Net debt is a concept that appears in many metrics that are relevant to our transaction. Net debt is found by subtracting the ending cash balance from the ending debt balance for each year. In our case, the ending debt balance is the balance on the senior notes and the subordinated notes.

Over time, we would expect the debt balance to decrease as senior debt is paid off. As a result, net debt tends to decrease over time. If net debt becomes negative, then this indicates that the cash balance is greater than the debt balance. In our case, we find this happening in the later years of our projection.

3. Calculating the Metrics (01:36)

There are several metrics that can be used to evaluate a company’s ability to pay its debts. In this lesson, we consider:

• Net Debt / EBITDA
• Net Debt / (EBITDA - CapEx)
• EBITDA / Net Interest Expense
• (EBITDA - CapEx) / Net Interest Expense

All the relevant figures can be found in our financial model. A lower value is better for the metrics involving Net Debt, while a higher value is better for the metrics using the Net Interest Expense.

4. Calculating the Debt Service Coverage Ratio (02:45)

The Debt Service Coverage Ratio compares the amount of cash available to pay down debt to the amount of debt that must be repaid each year. It’s calculated using the formula:

$$Debt Service Coverage Ratio = {Net Operating Income \over Total Debt Service}$$

In this formula, Net Operating Income is found by subtracting the interest expense from free cashflows. Total Debt Service is found by adding the interest expense and the mandatory principal payments on the senior bonds and the subordinated bonds. A higher value for this ratio is preferred, as it indicates the company is better equipped to make its debt repayments.

5. Interpreting the Metrics (04:07)

In our model, the debt service coverage ratio is low in early years, before increasing in later years as cashflows increase and debt reduces. A value for this ratio below one can be problematic, as it means that the company is using its cash balance to pay its debts. Obviously, this is only sustainable until the cash balance runs out. As a result, lenders would prefer to see a higher value for this ratio, of 1.1 or above, indicating that the company can pay its debts without using up its cash balance.

Transcript

In this lesson, we're going to calculate some key ratios for MarkerCo. In the past, we focused on operating metrics such as profit margin, EBITDA margin, and days receivable. Here, I'm going to focus on some new metrics that lenders will normally be very interested in. Primarily gauging the reliability of MarkerCo. to repay its loans.

As you can see from this list, the words "net debt" appear quite often. Net debt is a relatively simple concept and found by subtracting the ending cash balance from the ending debt balance each year. I'll now do this quickly, starting by calculating the total ending debt balance. This will equal to the ending debt balance for the senior notes plus subordinated notes.

And I'll copy across for the remaining cells.

And as you can imagine, the ending debt balance decreases over time as the senior notes are paid back.

To calculate net debt, I simply take this number and subtract the ending cash balance.

And again I'll copy across for the remaining cells. And as you can see, net debt turns negative in 2019 because the cash balance is now greater than the debt remaining. Let's now calculate our first ratio.

So I'll take net debt and divide by EBITDA which I can find in the Income Statement And I'll copy across for the remaining cells.

The next ratio I'm going to calculate is EBITDA divided by interest expense. Again I can find these numbers in my Income Statement, so I'll write equals, scroll up to my Income Statement, find EBITDA, and divide by the interest expense.

This can be found here. And I'll include a minus sign because I don't want my metric being a negative number. And I'll scroll across and copy with Ctrl + R.

As an exercise, try and complete these ratios replacing EBITDA with EBITDA minus CapEx.

Off camera, I will now perform these calculations to save some time.

The last metric I'm going to calculate here is the debt service coverage ratio which compares the amount of cash available to pay down debt against the amount of debt that must be paid each year up to 2020. So I'll start by taking the free cash flow and adding the interest payments to this number.

And then I'll divide by the amount of debt that must be paid back each year and interest.

So here's the interest plus the mandatory payment on subordinated notes plus the mandatory payment on senior notes. And I'll just change the sign of this also.

And I'll copy across for the remaining cells. And as you can imagine, the debt service coverage ratio grows over time as our debt is paid down. Off camera, I'm going to update the heading for this section and reformat these ratios so that they're easier to read. From a lender's perspective, the debt service coverage ratio is worrying, particularly in the early years. The larger interest and principle payments due cannot be covered by operating income, and as a result the debt service ratio is below one right up until year three.

A lender would ideally like this above 1.1 if at all possible. Essentially, Privak is using MarkerCo.'s large cash balance to pay debt down in the early years until EBITDA growth and a smaller debt balance improves my key metrics in later years. When analyzing these metrics, it's important to rationalize a story behind the numbers, as I have done here, that lets you know how the debt will be paid for and what causes a change in your values over the life of an investment. It's also worth noting that banks calculate the debt service coverage ratio in different ways and you may need to adjust this formula depending on how your client or the lender calculates the debt service coverage ratio.

Financial Modeling Essentials

Contents

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06:09

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04:44

#### 13. Conclusions and Improvements

04:35

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