Subscribe to our monthly Ledge Bulletin for the latest in WA business news

Financial Covenants: What you need to know in 2022

  • Home »
  • News »
  • Financial Covenants: What you need to know in 2022

Drawing graphs and writing numbers on a notepad with a calculator close by.Australian financial markets are constantly changing and with these changes comes a new lending environment. One aspect of lending that remains the same is the use of financial covenants. This article is an extension from our blog on Gross Leverage Ratio as we explore other common financial covenants used by banks.

In this blog we will explore:

  • What is a financial covenant?
  • What is the purpose of financial covenants
  • Why financial covenants are used
  • How the accelerated instant asset write off may impact your bottom-line
  • 4 most common financial covenants that you should know
  • What happens if the borrower breaches a financial covenant?

What is a financial covenant?

A financial covenant (also known as a debt covenant or banking covenant) is a condition or formal debt agreement put in place by lenders which limits the borrower’s actions. That is, certain rules that the borrower must abide by.

A financial covenant is a condition or formal debt agreement which Banks put in place that are required to be adhered to by the borrower.

What is the purpose of financial covenants?

For the lender

Protect the lender by limiting the borrower’s actions and preventing them from taking actions that may increase risk for the lender.

For the borrower

Provides the business with financial disciplines to ensure they don’t overextend themselves and put the business at risk.

Why are financial covenants used?

Financial Covenants vary from Bank to Bank, but broadly speaking there are 2 main areas that the bank is trying to monitor:

1. Serviceably

Put simply, can the company demonstrate that it can repay the bank loans?

2. Balance Sheet strength

How leveraged is the Company’s Balance sheet?   In other words, is it overly debt laden and can its short-term debts (e.g. Creditors etc) be covered by its short-term assets (e.g. Cash at bank, Debtors)? And is there retained equity held in the balance sheet (i.e. have they invested back into the business or drawn out all the profits)?

How the Accelerated Asset Write Off may impact your bottom line

If you are a business who has, or are thinking of, taking advantage of the instant asset write off, you need to be mindful of the effects this will have on your bottom line over the next 12 – 24 months.

The full cost of eligible capital depreciable assets may be written off in the first year of use, rather than at the usual rate of depreciation over the life of the asset.  While the benefit is that it results in a reduced NP position and therefore less Tax, the reduction in NP may mean that you breach Bank financial covenants.

Without sufficient bandwidth, you may find yourself in a position of breaching a covenant or putting yourself under too much pressure. That is, that the accelerated write off may impact a financial covenant such as a dividend policy/covenant where its calculated pre-tax versus after tax.

Why does this make a difference?  Well, if there is a “Dividend Restriction” covenant it can make a big difference.

For example, let’s say the covenant is “Dividends, distributions are restricted to 30% of NPAT”, and you’ve applied accelerated Asset Write off and thereby dramatically reduced you NPAT position, then this could potentially reduce the amount you can draw by way of dividend.

Therefore, before making the decision to purchase large assets you should speak to your trusted accountant or tax professional to determine how it will impact your cash flow and finances in the short term.

It’s important to note that there are subtle differences amongst banks, so it’s vital that you as the client are aware of these and be mindful of the covenants you agree to.

4 most common Financial Covenants that you should know

Please note that depending on the individual circumstance and industry, these financial covenants may need to be altered or the lender may need to introduce a covenant better tailored towards the client.

1. Interest Cover Ratio (ICR) >1.5x

It shows the number of times that interest expense on borrowings has been covered by EBIT (Earnings before Interest & Tax).  In other words, the ICR is a financial ratio used to determine how well the borrower can pay the interest component of outstanding debts.

ICR is calculated as follows:

EBIT ÷ Gross Interest Expense

    • EBIT = earnings before interest and tax.
    • Gross Interest Expense represents the interest payable on any borrowings.

As a rule of thumb, the ratio should be greater than 1.5x

This type of covenant may be appropriate for a property investor for example, as it is interest only.

2. Debt Service Cover Ratio (DSCR) ≥ 1.25x to ≥1.50x

The DSCR measures the ability of a company to use its operating income to repay all its debt obligations, including repayment of principal and interest on both short-term and long-term debt.  In other words, can debt servicing be demonstrated.

DSCR is calculated as follows:

EBITDA ÷ Gross Interest Expense + Gross Principal Repayment 

    • EBITDA = earnings before interest, tax, depreciation and amortisation
    • Gross Interest Expense represents the interest payable on any borrowings
    • Gross Principle Repayment represents any payment that reduces the amount due on a loan

As a rule of thumb, the ratio should be greater than 1.25x

Having a DSCR ratio of less than 1.25x would demonstrate that the borrower potentially won’t be able to pay the loan obligations, unless they count on outside sources.

3. Gross Leverage Ratio ≤2.25x to ≤2.50x

This Leverage Ratio, simply assesses the ability of a company to meet its financial obligations. It’s a ratio that helps to answer the question ‘how much debt should I have relative to my cash flow?’.

This is known as Gross Leverage Ratio and is represented by the formula:

Total Debt ÷ 12 months EBITDA

    • Total debt includes all external/bank term debt facilities
    • EBITDA = earnings before interest, tax, depreciation and amortisation

As a rule of thumb, the ratio should be less than 2.5x

4. Capital Adequacy Ratio / Debt to Equity Ratio 1 to 1.5x

The debt-to-equity (D/E) ratio is used to evaluate a company’s financial leverage and is calculated by dividing a company’s total liabilities by its shareholder equity. It is a measure of the degree to which a company is financing its operations through debt versus wholly-owned funds.

Debt to equity ratio is calculated as follows:

Total Debt ÷ Shareholders’ Equity

    • Total debt includes all external/bank term debt facilities
    • Shareholders equity represents what the investors/shareholders of the company own

As a rule of thumb, a good debt to equity ratio is around 1 to 1.5. However, it does depend on the industry. i.e. a capital-intensive industry will often have ratios greater than 2.

For example, a debt to equity ratio of 1.5 means a company uses $1.50 in debt for every $1 of equity i.e. debt level is 150% of equity. A ratio of 1 means that investors and creditors equally contribute to the assets of the business. A more financially stable company usually has lower debt to equity ratio.

What happens if the borrower breaches a financial covenant?

If there is a breach of a financial covenant, usually the lender will send out a letter acknowledging the breach and advising that they reserve their right to take action.

The lender can legally call the loan, demand repayment in full, enforce a penalty payment, increase the amount of collateral or increase the interest rate.

If the lender holds a GSA (General Security Agreement), this coupled with Covenants can be quite powerful. Therefore, it’s important that Covenants are appropriate and achievable before they are agreed to.

If this article has sparked any questions, please contact your Ledge Finance Executive directly, or contact us here and we will be able to assist.

Please note the information provided here is general in nature and does not constitute financial, tax or other professional advice. You should consider whether the information is appropriate for your needs and seek professional advice prior to making any decisions.

Option to download the financial covenants eBook.