A worked unitranche: four coverage ratios for one borrower, the EBITDA cushion to a 1.10x covenant, and what a rate rise does to it.
The fixed charge coverage ratio is EBITDA less unfinanced capital expenditure and cash taxes, divided by cash interest plus scheduled debt repayment. On an illustrative direct loan of $220M against $40.0M of EBITDA, that is 31.0 over 23.65, or 1.31x, while the same borrower shows interest cover of 1.86x. Against a 1.10x covenant, EBITDA can fall 12.5 per cent before the test breaks, and a 200 basis point rise in the reference rate takes almost all of that away.
Worked in full in The Private Credit Investor by Julian R. Sterling, with every figure reproduced in a free workbook.See the book on Amazon →
A sponsor-backed distributor borrows a unitranche at 5.5x leverage. The loan floats at the reference rate plus 575 basis points, amortises 1 per cent a year, and carries a single maintenance covenant: fixed charge coverage of at least 1.10x, tested quarterly on a trailing twelve-month basis. Every figure is illustrative.
| Input | Value |
|---|---|
| Covenant EBITDA | 40.0 |
| Unfinanced capital expenditure | 6.0 |
| Cash taxes paid | 3.0 |
| Unitranche term loan | 220 |
| Reference rate (illustrative) | 4.00% |
| Spread | 5.75% |
| Scheduled amortisation | 1% a year |
| Minimum fixed charge coverage | 1.10x |
Start with the denominator, because that is where the borrower's obligations sit. The all-in cash rate is 4.00 plus 5.75, or 9.75 per cent. On $220M that is $21.45M of cash interest. Scheduled amortisation at 1 per cent is $2.2M. Fixed charges are the sum: $23.65M.
The numerator is the cash the business generates that is actually available to meet those charges. EBITDA of $40.0M is not available in full: $6.0M goes on capital expenditure that is not separately financed, and $3.0M goes to the tax authority. What is left is $31.0M.
FCCR = (EBITDA − unfinanced capex − cash taxes) / (cash interest + scheduled principal)
= (40.0 − 6.0 − 3.0) / (21.45 + 2.2) = 31.0 / 23.65 = 1.31x
Excel: =(EBITDA-Capex-Taxes)/(Debt*(Base+Spread)+Debt*Amort)
Credit agreements vary, and the definition section is where the number is really decided. Some include restricted payments and dividends in fixed charges, some include capitalised lease payments, some deduct only maintenance capex. The structure, though, is always the same: cash after the unavoidable outflows, over the debt payments that cannot be deferred without a default.
The same borrower can be described with four different coverage numbers, all computed correctly. The difference is what each one leaves out.
| Measure | Formula | Result |
|---|---|---|
| Interest cover | EBITDA / cash interest | 1.86x |
| Debt service cover on EBITDA | EBITDA / (interest + principal) | 1.69x |
| After capex | (EBITDA − capex) / (interest + principal) | 1.44x |
| Fixed charge coverage | (EBITDA − capex − taxes) / (interest + principal) | 1.31x |
The gap between the first and the last line is 0.55x of coverage. A borrower presentation that leads with interest cover of 1.86x is not wrong. It is describing a company that does not spend money on equipment, does not pay tax and does not repay debt, which is not the company the lender has lent to.
A coverage ratio on its own says little until it is set against the covenant and turned back into earnings. Hold capex, taxes and fixed charges constant and solve for the EBITDA at which the ratio equals 1.10x:
Breach EBITDA = capex + taxes + 1.10 × fixed charges = 6.0 + 3.0 + 1.10 × 23.65 = 35.02
Cushion = 1 − 35.02 / 40.0 = 12.5%, or 4.98 of EBITDA
Holding taxes constant is conservative in one direction and generous in another: taxes would fall with earnings, but capex rarely does in the first year of a downturn. Run both in a full model. For a quick read across a portfolio, the fixed version is the honest one.
Had the same 1.10x level been written on interest cover, the breach would sit at EBITDA of 23.60, a 41.0 per cent cushion. The covenant level looks identical on the term sheet. The protection it buys is more than three times smaller under the fixed charge definition.
On a floating-rate loan, the denominator is not fixed at all. Every 100 basis points on $220M is $2.2M of extra interest, and the ratio responds immediately while EBITDA has not moved.
| Reference rate | All-in rate | Fixed charges | Interest cover | FCCR | EBITDA cushion to 1.10x |
|---|---|---|---|---|---|
| 3.00% | 8.75% | 21.45 | 2.08x | 1.45x | 18.5% |
| 4.00% | 9.75% | 23.65 | 1.86x | 1.31x | 12.5% |
| 5.00% | 10.75% | 25.85 | 1.69x | 1.20x | 6.4% |
| 6.00% | 11.75% | 28.05 | 1.55x | 1.11x | 0.4% |
Each 100 basis points of reference rate costs about 0.11 of coverage. At a 6.00 per cent reference rate, the borrower sits at 1.11x with an unchanged business, and the cushion is 0.4 per cent of EBITDA. Interest cover at the same point still reads 1.55x, which is why a lender watching interest cover alone would not see the breach coming.
That is the reason most direct lenders require a hedge on part of the loan for the first years, and the reason the hedge ratio belongs in the coverage analysis rather than in a separate section of the credit paper.
The frequent error is a mismatch of periods and bases. The numerator is taken on a pro forma, run-rate basis, with acquired EBITDA and cost savings annualised, while the denominator uses the interest actually paid over the last twelve months, at last year's lower rate and on last year's smaller debt. Both inputs are defensible on their own. Together they overstate coverage, because the ratio divides next year's hoped-for earnings by last year's cost of money.
The fix is to compute fixed charges on the debt outstanding at the test date, at the rate in force (or the forward rate, for the projections), and to state which add-backs sit in the numerator. If add-backs are material, show the ratio with and without them. The arithmetic of an add-back bridge is set out in what an EBITDA add-back bridge is actually worth in leverage turns.
The lender's model in the free workbook for this case computes coverage in a base, downside and stress case over five years, and the article on how much room a thin downside actually leaves shows which covenant fails first when the cases are run in reverse.
There is no universal level, but leveraged direct loans are often set, illustratively, with covenants between 1.0x and 1.25x, and the useful question is the cushion. In the worked case a 1.31x ratio against a 1.10x covenant means EBITDA can fall 12.5 per cent before a breach. A ratio of 1.31x with heavy floating-rate exposure can be weaker than 1.25x on hedged debt.
They share a denominator, interest plus scheduled principal, but DSCR in leveraged finance often uses EBITDA or cash flow available for debt service, while FCCR deducts unfinanced capex and cash taxes first. In the example, EBITDA over debt service is 1.69x and fixed charge coverage is 1.31x. Always read the defined terms in the credit agreement before comparing the two.
On floating-rate debt it enlarges the denominator at once. On $220M, each 100 basis points adds $2.2M of interest and removes about 0.11 of coverage. Moving the reference rate from 4.00 to 6.00 per cent takes the ratio from 1.31x to 1.11x with no change in the business, leaving 0.4 per cent of EBITDA before a 1.10x covenant breaks.
This article is one calculation from The Private Credit Investor. The book takes the same case from first principles to the decision, chapter by chapter, and every figure it prints is a live formula in the free companion workbooks.
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