Order Book Cover: a Worked Example

A credit decision on a manufacturer or contractor usually rests on next year's numbers, and next year's numbers start with revenue. Most of the cost base is decided before the year begins: the staff, the premises, the machines, the debt. Revenue is the line that moves. Order book cover splits it in two, the revenue already contracted and the revenue the business expects to win, and lets the lender put its doubt where it belongs.

The split also changes the conversation with management. A forecast defended as a whole invites a debate about optimism. A forecast in which a known share is signed and the rest is listed by prospect, by likelihood and by the date it must be won to be delivered in the year can be tested line by line.

The moving parts are the numerator and the period. Only orders that will be delivered, and so become revenue, inside the forecast year count: a three-year contract adds only its first year's share. What counts as firm varies. A signed purchase order, a contract with a deposit paid, a framework agreement with no committed volume and a letter of intent are four different degrees of certainty, and a business reporting its cover may include all four. Listed companies that publish cover partway through a year often include revenue already recognised in the year to date, which is why the mid-year version climbs as the year runs.

Under IFRS 15, applied in New Zealand and Australia as NZ IFRS 15 and AASB 15 and in the UK under UK-adopted IFRS, a company reporting in full discloses the transaction price allocated to performance obligations not yet satisfied at the reporting date and when it expects to recognise it, with practical expedients for contracts expected to last a year or less and for work billed as it is done. That disclosure is a contracted order book in accounting form. New Zealand's Tier 2 reporters are relieved of it, many mid-market borrowers in all three markets report under frameworks that do not ask for it, and the lender works from the business's own order schedule.

A maker of stainless-steel processing equipment for food plants, constructed for this page like every figure on it, presents a budget of US$24.0m of revenue for next year. Its order schedule shows US$13.2m of firm orders for delivery in the year.

Cover is below where the business has stood at this point in each of the last three years, and below that again once orders the customer can walk away from are taken out. The lender then sets the binding book against a different number: the revenue the business needs to cover its fixed overheads and debt service, US$6.5m a year in this example, at a contribution margin of 35%.

The budget needs US$12.8m of new or confirmed work; paying the bank needs US$7.4m. That second figure is the one the lender tests, by asking what has been won by this point in past years, how long the lead time is from order to delivery, and therefore by when the US$7.4m must be signed for it to be built in the year. Two of the binding orders were priced before the last rise in steel costs and earn less than the 35% margin, which the lender also adds to its list. The margin and the fixed-cost figure are the example's, not norms.

Book-to-bill divides the orders received in a period by the revenue billed in the same period. Above one, the order book is growing; below one, the business is consuming it. It measures momentum, looking back. Order book cover measures visibility, looking forward against a stated forecast. A business can have strong cover and a book-to-bill below one, living off a large order won last year and not replacing it, which a lender reading only cover would miss.

Backlog is the whole contracted book with no period attached; the IFRS 15 remaining performance obligations are close to it, though they count only what each contract makes enforceable. A contractor with US$60m of backlog spread across four years may have less cover for next year than one with US$20m all due within it. Cover turns the backlog into a statement about one forecast; the pipeline of unsigned prospects is everything that cover deliberately leaves out.

DEFINED IN ONE PARAGRAPH → · HOW BANKS TEST BORROWER FORECASTS → · HOW BANKS READ MANUFACTURING →

Cover decides which forecast the lender uses. A file in which cover is in line with past years can be assessed on the budget with ordinary sensitivities. One in which cover has fallen is assessed on a downside built from the binding orders up, and the question becomes whether the business can pay its way on that, not whether it will reach the budget.

It also decides the facility. A full order book is a working capital need before it is revenue: steel bought, labour paid and work in progress carried until each machine is delivered and invoiced. Customers who pay deposits often ask for an advance payment guarantee from the manufacturer's bank, which turns part of the order book into a contingent exposure for the lender. And the order schedule becomes a reporting requirement, delivered with the monthly accounts, because the next fall in cover is visible there months before it reaches revenue. Where one customer holds a large share of the binding book, the concentration is read as part of the same file.