Debt-Like Items: a Worked Example

The term comes from acquisitions, where a buyer negotiating the price bridge argues that certain liabilities should reduce what the seller receives, just as bank debt does. A lender has a different interest in the same list. It is not setting a price; it wants to know how many claims stand against the cash that services its loan.

The test is practical. Is the amount fixed or reasonably known? Does it fall due regardless of how trading goes? Was it incurred for something already received, rather than being the normal running cost of the business? An overdue tax bill passes all three. A trade creditor on normal terms does not, because it rolls over with the trade and belongs in working capital. Many items are arguable: buyers and sellers dispute accrued bonuses and deferred revenue, and a lender forms its own view.

Some items are market-specific. A defined-benefit pension deficit is mainly a UK issue on these files: where a scheme falls short of its funding objective, UK law requires a recovery plan, and the employer's agreed contributions are then a schedule of payments. Acquirers sometimes count the deficit after tax, and the accounting deficit can differ from the funding deficit the trustees use. Tax arrears carry extra weight because of ranking. In the UK since December 2020, unpaid VAT and employees' PAYE and National Insurance deductions have ranked ahead of floating charge holders. In New Zealand, Schedule 7 of the Companies Act makes unpaid GST and PAYE deductions preferential claims which, where free assets fall short, are paid from receivables and inventory ahead of most security over them. In Australia the tax office lost its priority in 1993, but directors can be personally liable for unpaid PAYG withholding, GST and superannuation guarantee charge.

Two cautions apply. An item should not be counted twice in one ratio: if a restructuring provision is added back to EBITDA, its cash cost still has to appear somewhere, and if it goes into debt, its payments should not also reduce the earnings. And the desk's reading differs from the contract's. A covenant counts only what the agreement's definition of debt includes, so a business can comply with a covenant on a figure the lender's own analysis does not accept.

A UK maker of commercial boilers, constructed for this page like every figure in it, has borrowings of US$18.0m, cash of US$2.0m and EBITDA of US$7.0m. Tax is US$0.7m, capital spending US$1.0m, interest US$1.3m and scheduled principal US$1.5m. Its accounts also show the following.

The maker borrowed nothing new to arrive at these numbers. Leverage is about a turn higher than reported, and this year's cash does not cover debt service once the other claimants are paid. The second reading is the sharper of the two. These levels are the example's and are not offered as a market norm.

The list also shows what stayed out. Customer deposits of US$1.5m are worked off through deliveries in the ordinary run of orders, so the lender left them in working capital; had the orders been cancellable with refunds, a part would have come in. A recurring warranty provision stayed out for the same reason. Next year looks different: the closure is done and the deferred consideration has one instalment left. A desk reads the item schedule year by year, because the problem here is a bulge rather than a permanent shortfall.

Net debt, as a facility agreement defines it, is a contractual measure. It often captures deferred purchase price and some guarantees, and it is what a covenant is tested on. Debt-like items are an analyst's addition to that figure, wider where the lender thinks the contract is too narrow.

Contingent liabilities depend on something that may or may not happen, such as a guarantee being called or a claim succeeding. They are read beside the balance sheet and weighted for likelihood. An item crosses over once the event has happened or the payment is scheduled: a provision about to become cash, or a claim settled and payable in instalments, is debt-like.

DEFINED IN ONE PARAGRAPH → · NET DEBT, AS THE DOCUMENT DEFINES IT → · DEBT TO EBITDA →

It changes three things. First, sizing: a lender that reads 3.36 times rather than 2.29 times is working from a different view of what the business can carry. Second, timing and structure: a known bulge can be met by reshaping principal in that year, or by a condition that deferred consideration is subordinated and paid only when cover allows it, which is usually written into the intercreditor or subordination terms. Third, the questions asked of the accounts. These items sit in provisions, accruals and notes, so a lender reads the notes, asks for the tax authority's payment plan and the trustees' latest valuation, and asks what has been added to or dropped from the schedule since the last review.

CONTINGENT LIABILITIES → · PREFERENTIAL CREDITORS → · FINANCIAL REPORTING, READ BY A LENDER →