FIN.12:5.2 - 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.