Debt Covenants and Potential Impact on Debt Classification

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covenant analysis

Recently, under the debt classification amendments 2020 to IAS 1, the International Accounting Standards Board clarified how an entity classifies debts as current or non-current in specific conditions. And the amendments will come into force for the reporting periods starting on or after Jan 1st, 2023.

What are Debt Covenants?

Debt covenants are the conditions/restrictions specified in a financial agreement by the lenders. The lender secures its interest with such terms. The borrower needs to maintain these conditions compulsorily. As an example, a lender may restrict its borrower from taking any other loan until 50% repayment of the existing loan. It can be a common informational covenant or ratio for every borrower in the books of the lender. Or it may vary by specific borrowers.

A borrower needs to maintain many ratios for financial covenant analysis, including EBITDA, debt to asset ratio, current ratio, cash flow, working capital, dividend payout ratio, interest coverage ratio, etc.

Affirmative Covenants and Negative Covenants

  • Affirmative or positive covenants are the actions that a borrower must perform to maintain the financial ratio/covenants at ideal values. Like a lender can ask a borrower to reach a certain level of a ratio.
  • In contrast, negative debt covenants are the conditions that borrowers need to refrain from. As an example, a company borrower can not pay dividends more than the set limit in the signed agreement.

How do Debt Covenants Impact Debt Classification – Defined Conditions

Violation and waiver are crucial to identify the impact of covenants on debt classification.

  • In case of covenant violations, the lender can exercise the right to call debt, ask for early repayment, renegotiate the agreement terms to avoid a future violation, and levy a penalty.
  • If a violation occurs, a borrower can request a waiver to get a grace period.

Impacts

A debt obligation requires periodic compliance with covenants specified by the lender.

Debt can be classified as a non-current obligation:

  • if there has not been a covenant violation that gives the right to call the debt to the lender,
  • and the probability is that the borrower can not comply with the covenant in the agreement within the year.

And if these two criteria have occurred, then the debt should be considered as a current obligation.

Debt can be classified as a current obligation if:

  • the lender has demanded early or immediate repayment for more than 12 months
  • the borrower has not cured the violation
  • the borrower will not resolve the violation issue within the provided grace period.

Example

The borrower D has a long-term loan with a repayment tenor of 5 years. And, the bank possesses the right to demand repayment immediately if the borrower can not maintain the specified debt to equity ratio at the calendar-end. The reporting period ends on 31st December.

Covenant Analysis

If the borrower maintains the debt covenant at the end of the reporting period, the loan is to be considered a non-current obligation, and if not, it is to be considered a current obligation because the lender can demand early repayment.