There must always be some limitations on the company’s ability
to incur the debt because unrestricted borrowings will harm the
bondholders of the company. So the bondholders require some type of
fixed coverage ratio tests to limit the debts outstanding.
Two common tests in bond credit analysis are :
- Maintenance
test : Maintenance test is concerned about the borrowers
ratio of earnings which is available for the payment of interest or
other fixed charges. Maintenance test requires this ratio to be at
least a minimum figure on each reporting date taken into
consideration. Such period can be quarterly or annually.
- Debt incurrence
test : The debt incurrence test is used when the company
wishes to go for some additional borrowing. For taking additional
debt, the bondholders require the interest or fixed charge coverage
ratio considered for the new debt to be a certain minimum level for
the reporting period prior to the financing. These are less
stringent than maintenance tests.