INTM577150 - Thin capitalisation: interest cover - debt servicing: Tests of cash flow sufficiency to pay interest and repay capital

There are several ways to test the sufficiency of cash flow of a company to service its debts. These are suggested as possibilities only, since cash flow covenants are not regularly used in the Advance Thin Capitalisation Agreement (ATCA) process. Possible approaches might be:

Method 1 - adjusting the EBITDA of the borrowing unit to arrive at cash flow

• Deduct - capital expenditure, loan repayments, increases in working capital, tax paid, dividends paid, acquisitions, share capital redemptions, non-cash credits and released provisions.
• Add back - new loans drawn, reductions in working capital, dividends received, proceeds of share issues, insurance payouts, non-cash debits and provision increases.

Is there a surplus which is sufficient to cover the expected interest payments and scheduled loan repayments? It should do these things as a bare minimum, and the ratio of surplus cash to interest plus loan repayments should be sufficient to also cover other expenses not already accounted for. If the company has a policy of paying dividends then the cash flow availability should include funds to meet the anticipated level of payments.

Method 2 - working from a cash flow statement prepared for accounting purposes

• From the Consolidated Cash Flow statement identify the net operating cash flow, which will typically be operating profit per P&L Account, plus/minus depreciation, amortisation, changes in working capital, pension charges and cash contributions, forex movements.
• A covenant for cash flow cover for the total of interest charged and all loan repayments may then be agreed.
• Where there are bullet loans (repayable in full at term), a notional annual figure may be included, probably on a straight line annual repayment basis.

The ratio should be greater than 1:1 on the basis that there will be other calls on cash flow, e.g. to pay dividends.

A variation would be to account for loan withdrawals and repayments, capital expenditure and asset sale proceeds within the cash flow exercise, and frame the covenant in terms of the interest charge alone. If all capital items have been caught in the above, the covenant may be in terms of net cash flow to interest charged.

The ratio chosen would need to leave sufficient cash available to fund the future of the business and provide a return for shareholders.

Method 3 - a more limited exercise to compare the interest charged in the Accounts with the interest actually paid in cash

• Identify the total Interest Charged to the P&L Account.
• Identify the Interest Paid per the Cash Flow Statement.
• Differentiate the interest paid in cash to third-party arm’s length lenders and interest paid to shareholder and other non-third-party lenders.
• If the interest charged to the P&L Account is greater than the interest paid per the cash flow statement, then the difference represents interest that has either been capitalised, or rolled up (same thing) into the loan, or is shown as a creditor elsewhere in the Balance Sheet.

Allow only the interest paid in cash for CT purposes, i.e. agree a covenant based on the cash paid per the cash flow statement. Care should be taken that interest is genuinely paid in cash and not dealt with as a drawdown of additional debt.

Method 4 - a detailed check of the assumptions, balance sheet figures, etc

• Obtain historic and forecast P&L Account’s together with a list of all the assumptions used to create the forecasts.
• Analyse the forecasts, agree with the assumptions and the application within the forecasts.
• Obtain the cash flow forecasts and ensure that they reflect the transactions within the P&L Account forecasts.
• Obtain Actual Balance Sheet as at the start of the Forecast Period, preferably Audited, but M/I is normally acceptable for this purpose, and projected Balance Sheet at the end of the forecast period.
• Ensure that the opening and closing cash balances accord with those shown in the Balance Sheet.
• Check that assumptions concerning phasing of receipts and payments, especially from debtors and to creditors of trading companies reflect the normal trading terms between all parties.

Identify the loan interest and loan repayments, and create a covenant for measurement against the net cash flow as shown in the forecast. Comments concerning appropriate levels of cover for interest cover as above apply equally here. The most appropriate level is one that gives comfortable cover, allowing for the fortunes of the underlying business to vary from forecast without putting interest payments, or indeed loan repayments in peril. Accordingly 1:1 is not normally appropriate and indeed 2:1 is normally far to low. Analysis of the business including the risks it faces and the relative volatility of its trading will indicate the most appropriate level.

Lenders are likely to continue to require higher than historic levels of interest cover in loan agreements, and HM Revenue & Customs agreements should reflect normal commercial terms and hence the level of debt commercially available at arm’s length. The level of cover should be sufficient to leave a high level of free cash flow available to the company and provide strong cover for interest payments. This means that for many trading companies 5 x cover would not be unusual, and 10 x cover may not be sufficient to achieve the purpose required.

Such a covenant may be in addition to an EBITDA-linked covenant, as is frequently seen in arm’s length bank agreements.