Debt Covenant Compliance and COVID-19
The impact of COVID-19 on corporate debt is prevalent in recent news. Credit rating agencies have downgraded US corporate debt, and Fitch forecasts the default rate to double in 2020, reaching 5 to 6%, primarily due to the COVID-19 crisis. Some economic forecasts expect default rates to reach 20% in some industries. Regardless, with $6.6 trillion in corporate debt, and close to $500 billion becomings due between 2020 and 2021, the corporate debt default risk is serious. Even though recent years have witnessed low-interest rates and loosened debt covenants, the impact COVID-19 is having on revenue generation, cash flow, liquidity, and asset devaluation may result in failures on financial covenants within debt compliance. Defaulting on debt covenants can have severe consequences on business, and many CFOs are focusing now on scrutinizing debt agreement terms and conditions, running scenarios through financial models, and assessing their risk.
Debt covenants – That’s another topic where there is plenty of information online to develop expertise, but let’s go through some basic definitions before we share our recommendations.
Debt covenants, or financial covenants, are conditions on loan agreements that restrict the debtor from taking specific actions or force the debtor to abide by certain rules, to protect the creditor’s interests. In simple words, it is an agreement between the lender and the borrower on how to operate to maintain the loan terms and conditions as contracted.
Covenants can be positive or negative. Negative covenants, or restrictive covenants, impose restrictions on the borrower or what not to do. Positive or affirmative covenants specify what to do.
The Corporate Finance Institute (CFI) lists 10 of the most commonly used metrics as covenants. In summary, leverage ratios dominate the list. Debt to EBITDA (Earnings before Interest Taxes Depreciation and Amortization), and Debt to EBITDA net of capital expenditures, which measure a debtor’s ability to pay its debt, are at the top 2 metrics, followed by interest coverage ratio and fixed charge coverage ratio, which measure the borrower’s ability to pay the interests on the debt. A fixed charge coverage ratio is a variant of the interest ratio that focuses on the ability to pay all fixed charges obligation, as opposed to only interest expenses.
Other ratios, such as debt to equity and debt to total assets, make a list, but the idea is the same. These accounting-based financial covenants try to ensure that the borrower is in a healthy financial position and can honor their obligations. Failure to do so, which is known as debt covenant violation, can have severe consequences. Defaulting to meet the consequences of the financial covenant can range from penalties, and an increase in interest rate, to a request for immediate payment and termination of the agreement. In many cases, depending on the severity of the situation, this can be the beginning of the end. Financial hardships and the inability to secure new loans are one of the top causes behind filing for bankruptcy.
But let’s put that dark image out of the equation and hope most businesses are not remotely close to this situation. There are things to do to keep debt under control:
- First, if you don’t have this in the back of your mind, read and understand the covenants, testing frequencies, implications and ensure there is an understanding of penalties in case of violations or compliance failures. If necessary, consult with an expert.
- Second, measure the probability of covenant violations by developing a covenant compliance forecasting model and ensure you are continually maintaining up-to-date financial projections. Run simulations to assess your limits, your warnings, and red flags.
- With COVID-19, we have also seen an unprecedented level of solidarity from governments, associations, and generous people alike. Explore available government relief programs and consider available payment deferral programs. In some instances, customers and communities are stepping in to help businesses in distress.
- Finally, start the dialogue, not only with your lender but with all stakeholders. Some options might be clearly stated in the debt agreement, while other options can only be uncovered through communication. Build a detailed plan that addresses available strategies and actions that may be needed to meet the requirements. Know how to implement your tactical plan and develop a comprehensive communication plan for all stakeholders that clearly explains the situation, resolutions, and actions taken.
Many of these tasks are not a day to day business and, though it does not sound intuitive to work with advisors and consultants when having financial hardships, the added value they can bring to the table is crucial to a timely resolution of the situation.