INTM516070 | Thin capitalisation: practical guidance: interest cover - debt servicing: cash flow and cash flow covenants

An important measure for a third-party lender is the cash-flow position of the borrower (see INTM515010). This is because a business may be profitable yet still fail because of a shortage of cash. Businesses over extend, the costs associated with income production getting out of synchronisation with the income itself. Companies may take on orders which they cannot afford to fulfil. If a company is obliged to borrow money in order to pay a dividend, it has profits which it cannot realise as cash. A cash flow statement may indicate whether a company can pay its employees, settle its debts, pay dividends, and whether it is solvent.

A company which cannot pay its debts is insolvent, and the risks of being regarded as such are serious for a company, both in terms of its reputation and because trading while insolvent is a criminal offence. There are many ways in which a company can augment its cash flow:

• Converting receivables into upfront cash (factoring)

• Delaying payment to creditors

• Awarding non-cash remuneration to employees

• Reducing trading stock, perhaps instituting “just in time” supply methods

• The sale and leaseback of assets which converts tangible fixed assets into cash, though at the expense of future cash flow.

Third party lenders will often include cash flow covenants in their agreements. In particular, EBITDA ratios are often used as a rough substitute for cash flow, both by lenders and by HMRC. Lenders may require EBITDA and cash flow covenants, but HMRC generally settles for EBITDA only. In practice, the relationship between EBITDA and cash flow in thin capitalisation agreements is often closer than might be assumed, since adjustments are often also made for pension and other provisions, capital expenditure, forex adjustments, and other items that distort the picture.

Flaws with EBITDA include:

• its reliance on profit and loss account data, whose figures may reflect non cash transactions, for example, accruals, trade debtors and creditors, adjustments to provisions.

• debt repayments are not included, nor is there any provision for the accumulation of funds to repay debt.

• no provision is made for capital expenditure

• working capital needs may vary during different accounting periods.

There are several ways in which a cash flow exercise could be carried out, and a number are summarised very briefly in INTM516080. These are suggested as possibilities only, since cash flow covenants are not regularly used in the Advance Thin Capitalisation Agreement (ATCA) process.