TOOL L5
Key Questions
- Under pressure the client will explore all the alternatives to massage the figures to avoid default. Does your definition minimise these “escape routes”? Items marked * below indicate escape routes available for the client.
- If accounting policies change, will the covenants still be measured under the original accounting policies at the date of the documentation?
- Is there a clear requirement for the client to show detailed calculations of the covenants in compliance documentation?
Balance Sheet – (Tangible) Net Worth
The principle here is to include only items that will
- Be permanent in the business.
- Have last access to assets and cash flows in times of pressure.
- Not require non discretionary repayment or financing costs at least during the tenor of the bank’s proposed exposure.
DO NOT RELY ON THE WORD TANGIBLE. COVENANTS CAN BE TITLED TANGIBLE BUT STILL INCLUDE INTANGIBLES IN THEIR DEFINITION.
| Item | Negotiation considerations |
| Common/ordinary shares | Provided it is fully paid. |
| Share premium | Confirm reflects share issue proceeds above nominal value. |
| Preference shares | Is dividend non discretionary? If so this has debt characteristics. |
| Redeemable shares | Who initiates the redemption, under what conditions and time-scale? |
| Legal reserves | Check that there are safeguards on reduction. |
| Revenue reserves | Can be inflated by extraordinary gains. |
| Revaluation Reserves | If you allow future revaluations (unless this is severely restricted by the GAAP) you are encouraging revaluation of assets to avoid default. |
| Translation reserves | Including this can be unfair to the bank and the customer depending on which way f/ex rates move. |
| Minority interests | – These can be increased by selling larger stakes in subsidiaries. – Minority interests are pari passu with holding company lenders. – Minority interests can be created with special off balance sheet structures yet retain the same features as debt. |
| Dividends declared | Under US GAAP these are shareholder funds but likely to be current liabilities shortly after the year end. |
| Treasury stocks | Must be deducted. |
| Investment grants / subsidies | Under what conditions would these have to be returned? |
| Convertible debt | Conditions of conversion? Compare to current share price. Is interest payable? |
| Subordinated debt | Confirm both principal and interest cannot be repaid until the bank debt has been fully repaid? |
| High yield debt (junk bonds) | To be included must be deeply subordinated as stated above. |
| Intangible assets | Deduction or limitation gives you more control over future bank financed acquisitions but may not reflect goodwill impairment (depends on accounting policy). Check whether this will be captured by an Income Statement covenant. Creation of intangibles other than on acquisition reflects capitalising costs. |
| Low quality assets | Related party / inter-company, and other assets that are liable to be written down should be deducted or limited. |
Debt
| Item | Negotiation considerations |
| Preference shares Convertible debt Subordinated debt | See comments in (Tangible Net Worth). |
| Short / long term | Excluding short term debt allows the client to control total debt levels. |
| Gross / net debt | If commercial pressures force use of net then a cap must be put on the cash / marketable securities in the calculations. Marketable securities should be tightly defined if they must be included. |
| Capitalised leases (on b/s) | Should be treated as medium term secured debt. |
| Operating leases (off b/s) | Should be measured on PV basis. This data is often not easily available. Control therefore may need to be exercised via restrictive covenants or EBITDA. If PV figure used you may need to make a compensating adjustment to include the assets financed by the operating leases in any leverage covenant. |
| Deferred consideration | Exclusion will allow acquisitions to be paid for later. |
| Inter-company debt | Exclusion will give the escape route for further funds to be injected on the covenant reporting date to prevent default. Only exclude if deeply subordinated |
| Contingent liabilities | Guarantees and L/C’s allow the client access to alternative funding. Take care with the construction industry and performance bonds. These should be controlled separately to prevent any decline in activity reducing performance bonds and allowing increase of debt. |
Total Assets
| Item | Negotiation considerations |
| Contingent liabilities | Should they be added to measure the true length of the B/S? |
| Revaluations Intangibles Low quality assets | Deduct those already excluded from the definition of (Tangible) Net Worth. |
Current Assets / Liabilities
| Item | Negotiation considerations |
| Inter-company | Exclude or inter-company transactions will distort the covenant. |
| Inventory | Limit the percentage in the total figure of current assets. |
| Other current assets / liabilities | Exclude any fixed asset, which has been reclassified as current. Under US GAAP include dividends payable as current liabilities. |
| Bills discounted | Decide whether they will be included here or in contingent liabilities. |
Income Statement
- Use actual data rather than annualised data.
- Rolling data allows more frequent compliance and eliminates seasonal factors.
EBITDA
The principle here is to measure the core operating profit only. The figure can be inflated by non-operational income. Inclusion of non-operational costs in the calculation will give much tighter control e.g. Goodwill impairment, restructuring costs.
| Item | Negotiation considerations |
| Accounting policies | Inventory, provisioning, depreciation (EBIT only), consolidation, extraordinary revenue recognition, capitalisation of costs and goodwill write off from reserves can all distort EBIT(DA). |
| Transfer pricing | Always a danger when using unconsolidated data or when there are non consolidated subsidiaries or associates. |
| Financial income | Even though it may be a regular source of income it is not part of the core business and may be non-cash. Take care on realised and unrealised gains on investments. |
| Book gains / losses | Inclusion encourages sale of assets or holding on to poor assets to avoid default. |
| Operating leasing | Should be included (unless EBITDAL is required) to avoid double counting. |
| EBITA | This is sometimes used on the assumption that depreciation is equal to non discretionary capex. Care with depreciation policy and the temptation to regard this as cash available for debt service. |
| Discontinued Operations / Acquisitions | Client may well request adjusted EBITDA. It is safer to keep to actual figures and handle this issue in a separate covenant. Note danger of using pro-forma numbers, which are often unaudited. |
Interest
The principle here is to include the true cost of debt. i.e. the non discretionary payments that have to be made for the financing of the business whether a profit is being made or not.
| Item | Negotiation considerations |
| Which debt | The cost of all the items included under debt above should be included in he definition of interest. |
| Gross / net | See comments under Debt. As a minimum the interest received should be capped. Interest received should not include dividend income. This assumes the investments are as liquid as cash. |
| Capitalised interest | Exclusion of this allows default to be avoided especially for capital intensive companies. |
| Non discretionary dividends | In some counties dividends are non discretionary by law. Also certain classes of shares (e.g. preference shares) have dividend obligations which are not wholly discretionary. Their non discretionary nature gives them the same characteristics as Interest. |
| F/ex losses | Where hard currency is borrowed but repayment depends on generation of local currency then these losses are likely to be a true cost of debt and should be included. |
| Fees | This is often a difficult item to identify. But where interest has been reclassified as fees they should be included. |
