Cash Netting Cap: a Worked Example

Net leverage gives a borrower credit for its cash, on the reasoning that cash could repay debt tomorrow. A lender accepts that only as far as the cash will still be there. A covenant is measured on a single test date, and the cash balance on that date is the most movable number in the accounts. A business can collect hard in the last week of a quarter, hold supplier payments back for a few days, or bank a customer's prepayment. Each lowers net debt on the day without changing what the business will owe once the week has passed.

The cap draws a line. Up to the cap, cash counts in full; above it, the covenant treats the business as if the extra cash were not there. Gross leverage, which ignores cash altogether, sits at one end of the range and uncapped netting at the other; a cap is a negotiated point between them. Nothing in New Zealand, Australian or UK law or accounting standards sets where that point falls. It is a term of the contract, agreed deal by deal.

Three drafting choices decide the result. The first is what counts as eligible cash before the cap is applied. Agreements commonly limit it to unrestricted cash, and many add conditions: the money must be withdrawable on demand or at short notice, free of any other creditor's security, and held by the borrower or companies that guarantee the loan. Cash posted as collateral or trapped in a subsidiary is usually out before the cap is reached. The second is the shape of the cap. It can be a fixed sum, or written to grow with the business, and some agreements turn it round and net only the cash above an operating balance the business is expected to keep. The third is where the cap applies: a document can net cash differently for the leverage covenant than for a margin ratchet or a permitted-debt basket.

A building-products distributor, constructed for this page like every figure in it, has borrowings of US$72m and EBITDA of US$16m for the twelve months to its June test date. On 30 June its accounts hold US$20m. Its facility agreement sets a net leverage covenant of 4.25 times and caps deductible cash at US$8m. Both levels belong to the example and are not offered as a market norm.

Uncapped, the distributor seems to have a full turn of headroom. Capped, it has a quarter of a turn. The difference lies in what the US$20m was:

Two days later the uncapped ratio has moved by more than half a turn with nothing in the business changed. The capped ratio has not moved, because the cash was above the cap on both days. That steadiness is what the lender bargained for: a covenant that reports on debt and earnings, not on the payment calendar. It is also what the borrower gave up, since a genuine surplus earns no credit beyond US$8m. Had the agreement excluded the offshore US$4m as trapped, eligible cash on 2 July would have been US$7m, below the cap, and the ratio 4.06 times (65 ÷ 16). In a thinner quarter, the definition of eligible cash decides the result, not the cap.

The two are confused because both are about cash, but they pull in opposite directions. A cash netting cap restricts the credit a borrower gets for holding cash; a liquidity covenant requires the borrower to hold at least a minimum. The first protects the leverage test from flattering balances; the second protects the lender from a business that runs dry. A file can carry both, and then the same balance is read twice: once as a floor the business must keep, and once as a deduction it may take only so far.

The cap also differs from the rest of the net debt definition. The cap governs what is subtracted; the definition of borrowings governs what is added. A lender who wins a tight cap but lets guarantees of others' debt, deferred purchase price or hedging close-out amounts fall outside debt has closed one side of the ratio and left the other open, the same gap the add-back cap addresses on the earnings side.

DEFINED IN ONE PARAGRAPH → · NET DEBT, AS THE DOCUMENT DEFINES IT → · THE TEST DATE →

The cap is argued in the term sheet, where a borrower with a large balance pushes to raise or remove it and a lender asks what the cash is for. Three answers change the reading. Cash that will fund an acquisition, a dividend or a capital project is leaving, and reduces net debt only until it goes. Cash that gathers in the last days of each quarter is a timing effect, and the months between test dates show it. Cash that builds steadily because the business generates it is the case for a higher cap, and a lender who sees that pattern across several quarters has reason to give ground.

Once the facility is signed, the cap shapes every compliance certificate. The headroom a lender reports to its credit committee is the capped figure, and a borrower near the line cannot rescue a tight quarter by holding cash over the date. That is the purpose. A covenant is meant to show the lender the business it lent to, and the cap keeps one day's bank balance from standing in for it.

LOAN COVENANTS, EXPLAINED → · DEBT TO EBITDA → · COVENANT HEADROOM →