Covenant Test Date: a Worked Example

A financial covenant mixes two kinds of number. Earnings, interest and debt service are flows, measured over a period that ends on the test date: most often the twelve months to that date, rolled forward each time, so that one strong or weak quarter does not decide the result alone. Debt, cash and net worth are stocks, read off the balance sheet on the test date itself. A leverage ratio puts one day's debt over a year's earnings, and the test date is what joins them.

For a lender the date matters because a covenant is a promise about the business on that day and no other. Between test dates the borrower can be well outside the ratio without being in breach of it. That is not a flaw in the drafting. It is the price of a test that can be checked against accounts, and it is why a lender reads the months between test dates as well as the test itself.

The calendar above belongs to the example that follows; agreements differ on every line. Test dates are commonly quarter or half-year ends, and some smaller facilities test only on the audited annual accounts. The delivery period for the certificate is a negotiated term, usually longer for year-end accounts than for quarters. New facilities often annualise a short history until a full twelve months exists. The fixed point is that the ratio speaks as at the test date, while the compliance certificate that reports it arrives later, so whatever has happened since is invisible in it.

A fresh-produce packhouse, constructed for this page like every figure in it, has a term loan of US$30m and a seasonal revolving line. Its EBITDA for the twelve months to 31 March is US$12m, and the month-end lines below hold that figure still so that only the debt moves. The facility caps net leverage at 3.25 times, tested at each quarter end. The level is the example's, not a market norm. In late March a large customer settled early to take a discount, and the packhouse set its grower payments for the fifth of the following month.

On the certificate the packhouse passes with 12.8% of headroom: earnings could fall by that much before the test fails. The month-ends either side tell a different story. On the average of the three, it sits just above the covenant, and the 31 March figure owes its comfort to the timing of two payments, not to the business. Nothing improper has happened, and the covenant has been met. But a lender who reports 12.8% headroom to its credit committee has reported the calendar.

Change one number. Had EBITDA been US$10m, the test-date ratio would have been 3.40 times (34 ÷ 10), a breach on 31 March. The lender would learn of it on 15 May, six weeks later, by which time the season, the revolver and the borrower's options had all moved.

The nearest neighbour is a covenant that applies at all times rather than on a date: a borrowing base, a loan-to-value limit tested whenever a valuation arrives, a minimum cash balance. These can be breached on any day, and a lender relying on them needs reporting frequent enough to see it. An incurrence covenant is a third kind, tested only when the borrower takes an action such as borrowing more. A file usually carries a mix, and the test date governs only the first kind.

The other thing a lender reads beside the test date is the borrower's balance date. For a borrower reporting under IFRS, including the New Zealand and Australian equivalents, IAS 1 as amended in 2022 (the same requirements carry into IFRS 18, which replaces IAS 1 from 2027) treats a covenant measured on the year-end position as affecting how the loan is classified, even if compliance is only assessed after the year end. If it is breached on or before that date and the loan becomes repayable on demand, the loan is shown as current unless the lender has agreed, by the year end itself, a period of grace ending at least twelve months after the year end. A waiver signed in the weeks after the year end comes too late for that set of accounts.

DEFINED IN ONE PARAGRAPH → · LOAN COVENANTS, EXPLAINED → · DEBT CLASSIFICATION ON BREACH →

The test dates are argued in the term sheet more often than people expect. A seasonal borrower wants its tests to fall at its low point of debt; a lender that agrees knows it is buying the flattering day and may ask for month-end reporting, or for net debt measured as an average of month-ends, to see the rest. Where a borrower's financial year ends on a test date, the timing of any waiver request moves forward, for the accounting reason above.

Once the facility is running, the gap between the test date and the certificate is where a relationship is tested. The borrower's directors usually know a breach is coming before the lender does. A request made before the test date gives the lender time to agree a waiver or a reset on terms; a breach first seen in a late certificate tends to arrive with a reservation of rights instead.

COVENANT HEADROOM → · WHAT TO SEND YOUR BANK EACH MONTH → · THE CASH NETTING CAP →