Leverage, coverage and covenants in an audit
Leverage ratios say how much debt the entity carries against its equity or earnings; coverage ratios say how comfortably earnings cover interest and other fixed payments. Lenders write them into credit agreements as covenants, so the same ratio can have a different definition in every loan. Debt may include or exclude leases and letters of credit, EBITDA usually has agreed add-backs and caps, and the fixed charge ratio may or may not deduct capex, taxes and distributions. This page uses one stated definition for each and shows the arithmetic; where the agreement differs, use the agreement.
For the auditor a covenant breach at the balance sheet date is a classification and disclosure question. Debt that is callable because of a violation is presented as current unless the lender has waived or lost the right to demand repayment for more than one year from the balance sheet date, or a cure is probable within a grace period (ASC 470-10-45-11). A breach, or tight headroom on the next test date, is also evaluated in the going concern assessment (ASC 205-40; AU-C 570). Recompute covenant ratios from the audited figures and the exact definitions in the agreement.
Common questions
What is the debt to EBITDA ratio?
Total debt divided by EBITDA. It estimates how many years of earnings before interest, taxes, depreciation and amortization it would take to repay the debt. Lenders usually set a maximum, and some measure it net of cash.
How is interest coverage calculated?
EBIT divided by interest expense, the form used here. Some lenders use EBITDA instead, so this tool shows both. A ratio under 1.0 means operating earnings do not cover interest.
What is the fixed charge coverage ratio?
A common bank definition is (EBITDA − unfinanced capex − cash taxes − distributions) ÷ (interest + scheduled principal + lease payments). Others start from EBIT plus rent. Check which one the agreement uses.
Why does it say "not meaningful"?
Ratios with a zero or negative base, such as debt to equity when equity is negative or debt to EBITDA when EBITDA is negative, have no normal interpretation. The covenant itself usually says how to treat them.
What happens when a covenant is breached?
The lender can usually call the debt. Under ASC 470-10-45-11 the debt is classified as current unless the lender has waived or lost the right to demand repayment for more than a year from the balance sheet date, or the agreement has a grace period and a cure is probable. The breach is also considered in the going concern evaluation.
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