Leveraged Lending

Cash Flow/Debt Service Coverage

Examiners should pay particular attention to the adequacy of the borrower’s cash flow and the reasonableness of projections. Before entering into a leveraged financing transaction, bankers should conduct an independent, realistic assessment of the borrower’s ability to achieve the projected cash flow under varying economic and interest rate scenarios. This assessment should take into account the potential effects of an economic downturn or other adverse business conditions on the borrower’s cash flow and collateral values. When evaluating individual borrowers, examiners should pay particular attention to:

The overall performance and profitability of a borrower and its industry over time, including periods of economic or financial adversity.

The history and stability of a borrower’s market share, earnings, and cash flow, particularly over the most recent business cycle and last economic downturn.

The relationship between borrowers’s projected cash flow and debt service requirements and the resulting margin of debt service coverage.

The level and composition of the borrower’s recurring cash needs and fixed charges, including the nature and extent of capital expenditures, cash taxes, and dividend payments.

Examiners should adversely risk-rate a credit if material questions exist as to the borrower’s ability to achieve the projected necessary cash flows, or if orderly repayment of the debt is in doubt. Credits supported by only minimal cash flow available for debt service are usually subject to an adverse rating when the credit analysis indicates that cash flows are not likely to materially increase in the near future, and hence refinancing is the only viable repayment option.

When assessing debt service capacity, examiners should use realistic repayment terms when overly liberal repayment terms or extended principal repayment requirements are coincident with unsupported or unrealistic cash flow and asset value projections. Also, loans that rely on refinancing or recapitalization as a source of repayment are largely speculative in nature. Because these repayment sources depend upon prevailing market conditions, they may be beyond the control of the borrower, and therefore the loans should have other reliable sources of repayment. Examiners should carefully analyze loans with repayment terms that continually rely on refinancing or fail to achieve successful recapitalizations.

When a borrower’s condition or future prospects have significantly weakened and well-defined weaknesses in the borrower’s repayment capacity are evident, leveraged finance loans will likely merit a substandard classification. If such weaknesses appear to be of a lasting nature and it is probable that a lender will be unable to collect all principal and interest owed, the loan should be placed on nonaccrual and will likely have a doubtful component. If such loans are within the scope of an institution’s policy for individual evaluation they should be reviewed for impairment in accordance with Financial Accounting Standards Board Statement (FAS) 114, “Accounting by Creditors for Impairment of a Loan.”

Previous: Risk-Rating Guidelines for Troubled Leveraged Loans Next: Using Enterprise Value