Covenant

Measure headroom in both debt and earnings

Hypothetical quarterly test. Use the 4.0× gross-debt limit above, with US$18m of defined debt and US$5m of defined trailing EBITDA.

Assume this maintenance test applies at quarter-end, excludes cash netting and uses those amounts without adjustments. Leverage is 3.6×; debt headroom at current EBITDA is US$2m.

With debt unchanged, EBITDA can fall to US$4.5m before the ratio reaches 4.0×. That is US$0.5m, or 10%, below the starting EBITDA.

It is not a 10% revenue cushion: fixed costs and margins can make a smaller revenue decline produce a larger earnings decline. At US$4m EBITDA, leverage would be 4.5×.

A filed credit agreement illustrates why financial covenants, events of default and amendment provisions must be read together. A failed test does not answer every question about notice, cure, waiver or acceleration.

Forecast the next test using its actual definitions and address an expected breach before relying on a lender remedy or accommodation.

Loan covenants can require actions or restrict them

• Affirmative covenant: an assumed obligation to deliver quarterly financial statements requires the borrower to do something by a stated deadline.
• Negative covenant: an assumed restriction on additional debt limits an action, subject to the permissions and exceptions in that agreement.
• Financial maintenance covenant: the leverage test above requires the defined ratio to remain within its limit at the specified testing dates.

A borrower can satisfy its leverage ratio and still fail a reporting requirement. Review each promise separately, including its qualifications and consequences, instead of treating the covenant package as a single number.