How tracking and forecasting your FCCR covenant cushion can prepare you for upcoming tightness and changes in investment capacity due to rate hikes.

Covenants are tighter than they appear

‎ ‎ ‎ ‎ ‎ ‎ Fourth quarter 2022 covenant compliance reports went to lenders this month. Given the pace of rate hikes during 2022 and the lag in effect on trailing twelve-month interest expense, reported interest is understated by more than 35% compared to run rate levels. As a result, fixed charge coverage ratios (FCCR) are overstated, as is borrowers’ “covenant cushion”, or the amount of room between the reported metric and covenant requirement.

‎ ‎ ‎ ‎ ‎ ‎ Over the coming quarters, covenant compliance reports will reflect the burden of run rate interest levels applying downward pressure on FCCR and FCCR covenant cushion.

‎ ‎ ‎ ‎ ‎ ‎ Borrowers unable to compensate with higher EBITDA will face increasing covenant tightness – restricting their capacity to invest in their business – and the potential threat of covenant breach.

Back-of-the-envelope math

‎ ‎ ‎ ‎ ‎ ‎ To do a back-of-the-envelope test of how your company will hold up under run rate interest levels, multiply your fourth quarter 2022 FCCR by 80% and re-evaluate your covenant cushion.

‎ ‎ ‎ ‎ ‎ ‎EBITDA. Due to EBITDA’s inverse relationship with operating expenses (OpEx), FCCR covenant cushion is a proxy for dollar capacity available to invest in new hires, systems upgrades, product launches / improvements, and other operating initiatives.

‎ ‎ ‎ ‎ ‎ ‎Capital Expenditures (CapEx). FCCR covenant cushion is also a proxy for dollar capacity available for longer-term capital investments, such as new equipment or facility expansion.

‎ ‎ ‎ ‎ ‎ ‎ Further, your covenant cushion has relationship implications with your lender – as it is a metric they will track and forecast to watch for signs of stress and use to evaluate your standing within their broader portfolio. A common theme in recent lender conversations is higher scrutiny on FCCR and debt service coverage and increased priority of downside / recession-scenario pressure testing as part of credit underwriting.

What can you do about it?

‎ ‎ ‎ ‎ ‎ ‎ Borrowers can’t control rates, but they can take steps to ensure loan covenants don’t interfere with growth:

1. Plan. Forecast and pressure test your next four quarters of covenant compliance and cushion to understand timing and drivers of potential tightness.
2. Adapt. Change what is under your control – such as the timing, magnitude and terms of OpEx and CapEx spending plans.
3. Communicate. Be proactive – don’t wait until you’re in covenant breach to find a solution.

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