A Closer Look at Debt Covenants

Oftentimes when companies are looking at financial covenants in a deal they will look at their forecast and they’ll compare the covenant level that a bank has proposed or a lender has proposed to what their plan is. And they’ll say, well I would really have to be way off plan in order to hit this covenant, so therefore I think it’s safe.

What they don’t always do is do a threshold analysis. A threshold analysis is you drop your operating performance in the forecast to the level just where you’re about to hit that level of covenant and you do it on a quarterly basis. So as you’re rolling forward, you can say okay if I’m at the threshold of the covenant now what does my balance sheet look like.

And often if you look at– not always but often– if you look at the cash level on your balance sheet and then you look at the debt level that the bank has lent to you, you have to look at the net cash position of the company where the net borrowing position of the company.

If you’re in default that’s a threshold of a covenant and you’ve got more cash in the bank than you’ve borrowed, then you paid interest for nothing because you didn’t get any real value.

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