Impact on liquidity

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Keep control of the process

There is enough to deal with as it is. Identify triggers, limitations and covenants in debt documentation (beyond the financial covenant report) to prevent surprises and keep control in dealing with financiers.

Ensuring access to cash is key

When a sudden shock hits the company, retaining access to cash is key. And sometimes, that shock even comes with a short-term spike in your funding needs, requiring some additional liquidity headroom.

Either way, it is prudent to look beyond the immediate issue and examine the potential domino effect. Will funding lines remain stable, reliable (open) and legally committed? In these times of uncertainty, is there sufficient liquidity headroom, including in less likely but bleaker scenarios and considering swings between months? To keep options open and retain the initiative (with banks too), it is key to start working on various scenarios, produce a plan A and B, and initiate discussions with financial and legal advisers.

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Company may be faced with covenant breaches

Various factors may unexpectedly impact the company's financial position. Even if the company can absorb financial losses and limit the damage, the shock itself may trigger financial covenant breaches or other, less obvious concerns in the company's financing arrangements. Financial implications tend to result in either a covenant breach or a liquidity shortfall. The covenants most likely to be breached relate to:

  • a material drop in EBITDA.
  • Most companies, however, use a definition of EBITDA in their financial covenants that deviates from the reported EBITDA number. The covenant EBITDA (often referred to as "Adjusted EBITDA") typically allows the borrower or issuer to normalise reported EBITDA by adding back certain exceptional items. This carve-out allows normalisation of the negative financial impact on EBITDA of one-off, unexpected events that are unrelated to the company. These add-backs were, for example, quite common at the onset of the COVID-19 pandemic and during other sudden shock events.
  • Important breathing space comes from the lesser-known fact that covenants are tested against quarter-end but lead to a default only once the compliance certificate must be delivered. This is typically 30 to 45 days after the last day of the quarter and allows the company to negotiate a waiver with the banks. This period tends to be sufficiently long, provided the company can show the various scenarios most likely to occur,as well as a plan A, plan B, etc.
  • Supply chain issues, war, market volatility or company-specific one-off events may be so disruptive to the company's business, that it constitutes a Material Adverse Change (MAC) or Material Adverse Event (MAE).
  • An event of default triggered by certain undertakings relating to sanctions, bribery and fraud depending on the issue at hand.
  • Where the company is part of a group of entities, a default under one or more facilities of one group entity could have a knock-on effect on other facilities. This means that a check on any cross-default or cross-acceleration must be performed.
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13-week liquidity forecasts may be required

To assess whether a liquidity shortfall is likely to occur, banks will almost always ask for a 13-week liquidity forecast showing the company or group's liquidity headroom. This forecast shows the expected development of liquidity (including committed revolvers or overdraft facilities but excluding uncommitted lines) in each of the next 13 weeks (by week-end). It allows the board to decide whether to postpone certain payments or accelerate collection of receivables. More importantly, this forecast allows the board to initiate discussions with banks as it is one of the first things banks request when asked to provide additional headroom.

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Lisa de Boer

Senior Associate