Liquidity Covenant: a Worked Example

A leverage covenant divides debt by earnings. When earnings are negative, the ratio has no meaning, and when they swing from quarter to quarter it says more about timing than about risk. Lenders to a business growing at a loss, a company part-way through a turnaround, or a project that has not started earning need a test that still works. The one thing such a business cannot survive is running out of money, so the lender measures that directly.

Liquidity covenants also appear for a time in loans that normally carry earnings tests. When a borrower's EBITDA falls and the lender agrees to suspend or reset the leverage test, a minimum liquidity requirement often takes its place for the waiver period. The lender gives up a measure that would be breached anyway and gains one that shows, month by month, whether the business can keep going while it recovers.

The definition does the work. Eligible cash is commonly limited to unrestricted cash held by the borrower or its guarantors, often in accounts over which the lender has security, so cash posted as collateral, trapped in an overseas subsidiary or held for customers stays out. Undrawn facilities count only if they are committed and could be drawn on the day; an uncommitted line, or a revolving facility that a default would stop, adds little. The minimum can be a fixed sum, a schedule that steps down as the business reaches milestones, or a number of months of forecast spending. The test can fall at each month end, each week, or apply at all times. Agreements commonly pair it with a compliance certificate and a cash flow forecast, and some allow an equity cure if the shareholders inject cash.

A subscription software business, constructed for this page like every figure in it, borrows a US$20m term loan to fund growth while it still loses money. At signing it holds US$14m of cash and has a committed US$3m revolving facility undrawn. The covenant requires liquidity of at least US$5m at each month end. That floor is the example's and is not offered as a market norm.

On its plan the business reaches the floor in month eleven and would run dry in month fifteen or sixteen. The covenant therefore trips with four to five months of funding still in hand, which is long enough to raise equity, sell the business or cut costs, and long enough for the lender to take part in that conversation. If spending rises to US$1.5m a month the dates move closer, but the gap between the floor and zero is still between three and four months.

The revolving facility is the weak point. It counts as US$3m of liquidity only while it can be drawn. If the agreement lets the lender refuse a drawing once a default is continuing, the breach itself can take the US$3m away. At the floor the business holds US$5m of liquidity on paper but only US$2m of cash it can spend: under two months at US$1.1m a month, under a month and a half at US$1.5m. The months of warning the floor was meant to buy shrink to less than two.

Liquidity headroom is a reading: the cash and committed facilities a business has above what it needs, which an analyst works out whether or not any covenant mentions it. The liquidity covenant is a contractual floor on one version of that reading, measured on the agreement's definition and on its test dates. A business can have thin headroom and pass the covenant, if the floor is low or the definition generous, or have comfortable headroom on the analyst's measure and fail it, if the definition excludes cash the analyst counted.

It also sits opposite the cash netting cap. A netting cap limits how much credit cash earns in a leverage test; a liquidity covenant demands that a minimum be kept. A loan with both reads the same balance twice. And it is a maintenance covenant, tested whether or not the borrower does anything, unlike an incurrence covenant that bites only when the borrower takes on debt or makes a payment.

DEFINED IN ONE PARAGRAPH → · THE 13-WEEK CASH FLOW → · COVENANT HEADROOM →

The level of the floor is the decision. It is commonly set from the forecast spending and the time a rescue would take: a refinancing, an equity round or a sale process each has its own lead time. A floor too close to zero gives warning when nothing is left to talk about. One too high trips while the plan is on track and turns a growth loan into a series of waivers. The test frequency is part of the same choice, since a monthly test on a business burning a million dollars a month leaves a month of spending unwatched between readings.

When the floor is breached, the lender's options are the usual ones, a waiver, a standstill or a reset, but the conversation is different. There is no argument about adjustments to earnings; the cash is either there or not. The useful questions are what the money is being spent on, when it stops being spent, and who will put more in. A lender that has received a regular cash forecast since signing already knows much of the answer, which is what the forecast was for.

LOAN COVENANTS, EXPLAINED → · WHEN A LOAN GOES BAD →