The Covenant Cushion
You are the credit analyst covering a TSX-listed manufacturer. For FY2025 it reports revenue of $310 million and EBITDA of $48 million, which includes $6 million of add-backs: $3 million of restructuring, $2 million of stock-based compensation, and a $1 million 'one-time' legal charge that has appeared in each of the last three years. Cash interest was $9 million, cash taxes $6 million, capital expenditures $14 million (management says $4 million of that is growth capex), and the increase in non-cash working capital was $5 million. Day sales outstanding rose from 58 to 71 days and inventory days rose by 20. The company pays $12 million a year of dividends on $200 million of preferred shares and carries $150 million of total debt. Its revolver covenant is net debt to consolidated EBITDA of 3.25x or less, and the definition permits all of the add-backs above. Management is marketing a new issue of preferred shares and describes its free cash flow as strong with comfortable covenant headroom.
1. Compute sustainable EBITDA, free cash flow after preferred dividends, and covenant headroom. Is management's characterization defensible?
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Reported EBITDA of $48 million overstates sustainable cash earnings. The legal charge has recurred for three years and is an operating cost. Stock-based compensation is a real economic cost that dilutes shareholders and should not be added back in credit work. Restructuring in three consecutive years is likewise questionable. A defensible figure is about $42 million; stripping only the recurring legal charge gives $47 million.
Covenant: net debt/EBITDA = 150/42 = 3.57x against a 3.25x limit - a breach, not comfortable headroom. To stay inside 3.25x, EBITDA must be at least $46.2 million. Even on management's $48 million the ratio is 3.13x, leaving 0.12x, which a 4% EBITDA decline wipes out.
Free cash flow: 42 - 9 interest - 6 tax - 14 capex - 5 working capital = $8 million. Preferred dividends of $12 million exceed that by $4 million, so the shortfall is funded by the revolver, which raises net debt and worsens the ratio again next year. Even accepting management's $10 million maintenance capex figure, free cash flow is $12 million - coverage of 1.0x with no cushion.
Management's description is not supportable on the numbers presented. At best, the company has no room for a bad year.
2. What do the DSO and inventory trends tell you, and what quality-of-earnings questions would you ask?
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These are classic signs of deteriorating quality of earnings. Revenue of $310 million at 71 DSO implies receivables of about $60.3 million; at the prior 58 days, about $49.3 million. That is roughly $11 million of additional receivables - more than double the $5 million working-capital increase management reports. Either the working-capital figure excludes something, or sales are being recognized on terms that do not convert to cash.
Questions to ask:
- Is revenue being pulled forward with extended terms, bill-and-hold arrangements, or quarter-end loading? Compare quarterly revenue with cash collections.
- How has the receivables aging moved? Are 60-90 day buckets growing, and what are bad-debt allowances and credit notes?
- Customer concentration: is a large customer delaying payment or disputing invoices?
- Inventory days up 20: a deliberate build for a contract, or obsolete finished goods? What is the provision and what are turns by product line?
- Are payables being stretched to mask the working-capital drain? Check DPO.
- Do the add-backs recur, and what would EBITDA be if the one-time items were treated as ongoing?
A company whose receivables grow faster than revenue usually has a revenue-recognition or collection problem, and free cash flow will keep disappointing.
3. Recommendation on the new preferred issue: buy, avoid, or need more information? What would change your view?
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Avoid the issue. The credit is weaker than the marketing suggests: 3.57x leverage on sustainable EBITDA against a 3.25x covenant, and a $12 million preferred dividend not covered by $8 million of free cash flow. Preferred dividends are discretionary, but a company this close to a covenant breach may be forced to suspend them, and the preferreds rank behind $150 million of debt. A thin secondary market and an embedded selling commission add to the risk.
What would change my view:
- A covenant amendment or an equity raise that brings net debt/EBITDA below about 2.5x on sustainable EBITDA.
- Disclosure showing the receivables aging is stable and the DSO increase is a mix or timing effect.
- A capex cut that lifts free cash flow coverage of the preferred dividend to 1.5x or better.
- A yield that compensates - for leverage at this level, several hundred basis points above the proposed coupon.
Before committing, request the full covenant definition, the trailing four-quarter compliance certificate, and a receivables aging schedule. If the issuer will not provide them, that is itself the answer.