The formulas, tricks and trade secrets of Private Equity

A reader, **Nicolas**, recently asked the following question:

While the use of the fixed charge ratio seems to be quite straightforward (FCF / Debt Service), I was wondering why didn’t we also use FCF / Interests Expense (instead of EBITDA / Interest Expense) when calculating interest coverage in debt covenant calculation.

It seems more natural to use FCF and more logical to be homogeneous in the numerator used. I might be mistaken on that but these are my thoughts. Do you have any explanation on that?

This could also be applied to EBITDA / Net Debt no?

In calculating interest cover (in debt covenant calculation), we must make sure we’re **not double counting** interest by using a numerator that has had interest taken out already. Let’s look at an example.

Say my interest expense is $10 and I have $15 spare to pay the interest. My interest cover is 1.5x. The problem with using net cash as the numerator, is that it has already had interest removed (and a tax shield applied and whatever else affecting the result). So in the example, it would look approximately like ($15-$10)/$10, which is only 0.5x. This suggests I don’t have enough to pay my interest.

With that said, **FCF can mean different things**. Some people calculate free cash from an equity holder’s perspective, some from the deb holder’s perspective, and others from the firm’s perspective. The reason I mention this is that if your “FCF” is pre-interest, then it’s much more suitable for the interest cover calculation than FCF post-interest. In most textbooks, the method of debt covenant calculation is indicated by the acronym, e.g. FCF, FCFE or FCFD, but in practice it’s worth checking.

Now back to your question: **what about the debt service ratio**? Why does it use FCF rather than EBITDA. Again, it comes down to timing and classification. Principle repayments and interest expenses are rarely classified in the same manner. And FCF is often calculated before principle repayments are removed, making FCF a valid numerator. But it’s not perfect when you get into the detail and when it comes down to it, the banks have all the say and they generally try to take a conservative view of practical applications.

I hope that helps Nicolas with debt covenant calculations, but hopefully other readers can add some colour.

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