Distress and capital-structure restructuring

Capital structures break. Sometimes because the business deteriorates faster than expected; sometimes because rates move and a structure that worked at 8% interest can't survive at 14%; sometimes because of a specific shock (a major contract loss, regulatory action, FX crisis). When the structure breaks, the company needs to either find new capital, renegotiate existing capital, or both. This module covers what that process looks like from the corporate-financing side.

Coverage ratios — the early-warning formulas

Before a capital structure 'breaks' visibly, it deteriorates through a sequence of coverage-ratio breaches that credit officers monitor every quarter. The two most-cited coverage ratios are interest coverage and the debt-service coverage ratio (DSCR), each capturing a slightly different question about the firm's ability to service its capital structure from operating cash flow.

                          EBITDA
  Interest coverage  =  ─────────────────
                          Interest expense

                          EBITDA  −  Tax  −  Maintenance capex
  DSCR               =  ───────────────────────────────────────────
                            Interest expense  +  Principal repayment

                          Total debt
  Leverage ratio     =  ──────────────
                            EBITDA

where:
  EBITDA              =  earnings before interest, tax, depreciation, amortisation
                          — the operating cash-flow proxy (annualised)
  Interest expense    =  the annual interest cost on outstanding debt
                          — pulled from the income statement; sometimes
                            grossed up for capitalised interest
  Tax                 =  cash taxes paid (estimated from effective rate × EBIT)
  Maintenance capex   =  the capex required to keep current operations running,
                          excluding growth investment — often estimated as D&A
  Principal repayment =  annual scheduled debt amortisation, excluding refinancing
  Total debt          =  all interest-bearing debt at book value
  Leverage ratio      =  Debt / EBITDA — the headline single number
                          credit officers and rating agencies anchor on

Why each coverage ratio matters

• Interest coverage > 5x — comfortable, IG-typical. Below 3x is yellow-flag for IG; below 1.5x is bank-covenant zone where the company is one quarter of weak operations from breaching.
• DSCR > 1.25x — typical lender minimum on a term loan; project-finance lenders often require 1.30-1.50x. DSCR < 1.0x means the operating business cannot service principal-plus-interest from its own cash flow, which forces refinancing or equity injection.
• Leverage ratio < 3.0x — IG corporate range. 3-5x is sub-IG investment-grade-adjacent. 5-7x is high-yield. Above 7x is heavily-leveraged territory. Banks typically cap commercial-loan leverage at 3-4x EBITDA depending on industry and seniority.

Signs a capital structure is breaking

• Interest coverage falling below 1.5x — bank covenant zone (the formula above made explicit).
• Liquidity declining quarter-on-quarter — cash + undrawn lines declining.
• Multiple covenant breaches in 12 months — typically triggers waiver fees and tighter terms.
• Refinancing approaching with no clear plan — looming maturity wall.
• Auditor flagging 'going concern' issues in the annual report.
• Bonds trading below par with rising yields — market sensing trouble.

The workout playbook from the financing side

• Step 1 — internal diagnosis: CFO and CEO assess realistic recovery path. If operations are fundamentally sound but balance sheet is wrong, restructuring works. If operations themselves are broken, more capital just delays the end.
• Step 2 — engage advisors: investment-bank turnaround team or specialist restructuring advisor (Houlihan Lokey, PJT Partners, FTI). They provide diagnosis, run process, manage creditor engagement.
• Step 3 — engage creditors: lenders convene; majority creditor agreement is typically needed for any restructuring. The lawyers run point on negotiations.
• Step 4 — propose restructuring: covenant resets, maturity extensions, principal haircuts (typically 20-50%), conversion to equity for some debt, sometimes new money in priority position.
• Step 5 — execute: restructuring documents signed; equity dilution often substantial; new capital flows; covenants reset.
• Step 6 — recover: 12-24 months of execution against the restructured plan. Performance issues are tracked weekly.

Debt-for-equity swap — the cleanest fix

If a business has $1bn of debt and $200m of equity, with EBITDA collapsed to $80m, debt service alone is unaffordable. The cleanest fix: convert $400m of debt to equity. Now debt is $600m, equity is $600m (old equity gets diluted to 15% of new total). Debt service falls; the business has runway. The original lenders give up some claim but get 65% of the equity in exchange. If the business recovers and re-IPOs at $1.5bn, the lenders recover much more than they would have in a liquidation.

Recapitalisation via rights issue

Sometimes existing shareholders can recap a company through a deeply-discounted rights issue. The company issues new shares at 30-70% discount to current (broken) price. Existing holders subscribe; new equity comes in; debt gets repaid; the business gets runway. This works when existing shareholders have capital, faith in the recovery, and a controlling stake worth defending.

Bankruptcy as last resort

If out-of-court restructuring fails, formal insolvency proceedings (Kenya's Insolvency Act, US Chapter 11, UK Insolvency Act 1986) provide structured frameworks for restructuring. Chapter 11 is generally faster and more debtor-friendly than other regimes. Kenyan administration takes 4-6 years on average. The threat of bankruptcy is what disciplines out-of-court negotiations — most distressed credits resolve out of court precisely to avoid the bankruptcy outcome.

Where to from here

Twelve modules of corporate financing. From here: the Investment Banking course teaches the buy-side and sell-side of M&A and capital raising; the DCF Valuation course teaches the discount-rate math underneath; the Credit course teaches what the lenders are evaluating. Together they form the financing-side curriculum every senior corporate-finance professional carries. Mwalimu — your AI tutor — can walk you through any of them, and can take questions on your own company's capital structure if you bring real numbers.