FIN.12:5 - Archetypal Grounding

A constructed facility tests debt/EBITDA at quarter end with a maximum of 3.0, using the agreement’s supplied definitions. Tested debt is 240 and EBITDA 100: the ratio is 2.4 and permitted additional debt at unchanged EBITDA is 60. If EBITDA falls to 80, the same debt reaches 3.0 and that headroom disappears. A proposed debt-funded payment of 20 produces 260/80 = 3.25. This plan cannot rely on the original headroom under that scenario. A repayment of 20, different permitted financing or an actual amendment can change the result; a hoped-for waiver cannot.

A cash remedy must also fit its borrowing permission

Take the adverse account in FIN.2: week-1 receipts are delayed, the borrowing base permits 20, and an agreed supplier deferral of 15 allows a draw of 20 to preserve cash reserve 10. Add a stipulated condition tested before each draw: total debt divided by the agreement’s qualified earnings measure must not exceed 3. Existing included debt is 70, with no additional service within that account’s horizon, and the qualifying earnings measure is 30. The draw of 20 gives 90/30 = 3. It is allowed under this test, but leaves no debt headroom under that unchanged measure.

If the qualifying earnings measure instead becomes 25 before the draw, this test permits total debt only 75 and hence an additional draw of 5. That limit is tighter than the borrowing base of 20. After the supplier deferral, week-1 cash before drawing is −10; drawing 5 leaves −5, or 15 below the selected reserve. The earlier liquidity remedy is no longer sufficient.

Actually settled new equity of 15 before week-1 payments, with the draw of 5 and the same supplier deferral, would restore cash to 10 under the supplied terms. An unaccepted equity proposal would not. Recompute later balances, interest and repayment in FIN.2 before relying on the whole route. Alternatively an obtainable covenant amendment could permit the larger draw, but its fee and every remaining condition would need to return to that account.

The example’s earnings definition and draw test are stipulated contract terms, not a claim about all loan agreements. If the rule is instead tested at quarter end or grants a particular cure, model those events explicitly; do not import this draw prohibition by analogy.

A debt-reducing disposal can tighten the covenant

In a separate constructed disposal, included debt is 70, qualifying annual earnings are 30 and usable cash is 10. The agreement caps debt/earnings at 3, with no cash netting. It permits the disposal only if the test passes immediately after closing: all net sale proceeds must repay debt, the disposed operation’s earnings are removed at once, and a sale gain cannot enter qualifying earnings. The current ratio is 70/30 = 2.33, with headroom 20.

An attainable offer provides net sale proceeds of 20 and removes qualifying earnings of 15. Debt therefore falls to 50 and earnings to 15. The new ratio is 50/15 = 3.33 and headroom is 3 × 15 − 50 = −5. Applying the sale proceeds to debt has worsened access; retaining the old denominator of 30 would hide the breach.

On these definitions, the disposal requires total debt repayment of 70 − 3 × 15 = 25. The buyer’s 20 is short by 5. Paying that difference from existing cash makes the ratio pass but leaves cash 5, below the corporation’s required reserve of 10. The cash sweep and extra repayment must therefore be considered together.

If an investor actually settles equity of 5 before closing, the company can use the sale proceeds of 20 and that 5 to repay 25. Debt becomes 45, earnings 15 and cash remains 10; the ratio is exactly 3. Account for the investor’s rights and future operating/service consequences in the financing and cash comparison. A new included loan of 5 followed by repayment of 5 of old debt leaves total debt 50 and does not repair this test.

A net sale price of at least 25 could instead cover the required repayment without consuming the reserve, if such an offer is obtainable and all other terms remain the same. Until a sufficient remedy or amendment is effective, the original 20 offer is not a permitted disposal under the stipulated rule. Whether the disposal creates value is FIN.9’s additional question; a repaired covenant calculation does not answer it.