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The covenant, and the clause that trips it

Operating profit falls from ₹800 crore to ₹600 crore. Not a rupee more is borrowed, net debt is unchanged, and no cash moves. In the accounts, ₹2,150 crore crosses from non-current to current liabilities and the auditor adds a paragraph.

Fundamental AnalysisAdvanced14 min read

Written by Onam SharmaLast reviewed Report a correction

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A company has an ordinary bad year. Volumes are flat, input costs rise faster than it can pass them on, and operating profit before depreciation falls from ₹800 crore to ₹600 crore. There is no fraud, no write-off and no crisis. It borrows nothing further, and its net debt on 31 March is ₹2,250 crore, exactly what it was twelve months earlier. Then the accounts appear, and ₹2,150 crore that was presented as non-current borrowings last year is presented as a current liability this year, the current ratio has gone from unremarkable to alarming, and the auditor has added a paragraph about material uncertainty. No money has moved. What moved was a ratio past a number written into a loan agreement years ago that almost nobody reading the annual report has ever seen.

Think of it like this
The clause in the leave-and-licence agreement

The agreement says the owner may terminate on a month’s notice if the flat is sublet. You let a cousin stay in the spare room for two months and the owner finds out. He does not want you to leave — finding a new tenant is work, and you pay on time. He wants the rent revised at renewal, and he mentions the clause. The clause was never valuable to him as an eviction. It was valuable because he now has it and you now know he has it.

In the market

A covenant breach very rarely produces a demand for repayment. It produces a lender who is entitled to demand repayment, which is a bargaining position — used for a higher spread, additional security, a promoter guarantee, a restriction on dividends or capital expenditure, or simply a closer seat at the table.

What a covenant is, and what it is tested on

  • Financial covenants are ratios the borrower undertakes to maintain: a maximum net debt to operating profit, a minimum interest cover or debt service cover, a minimum security cover on charged assets, a minimum tangible net worth. They are tested on defined dates — commonly annually or half-yearly — and the borrower certifies compliance to the lender.
  • The definitions are the agreement’s, not the annual report’s. "EBITDA" in a facility agreement is whatever that agreement defines it to be, and the definition frequently differs from the published figure: exceptional items excluded, a subsidiary’s earnings included or excluded, the full-year effect of an acquisition annualised. A company can therefore comply while the ratio you compute from the accounts appears to breach, and occasionally the reverse. Where a company discloses covenant compliance, it is stating the agreement’s answer, not yours.
  • Non-financial covenants are undertakings rather than ratios: a minimum promoter shareholding, no change of control without consent, no disposal of specified assets, no borrowing beyond a stated limit, no dividend above a stated payout while the facility is outstanding.
  • A cross-default clause defines a default under one facility as a default under this one. It is what turns a local problem — one subsidiary, one lender, one missed certification — into a group-wide event, and it is the reason distress in a large borrower moves so much faster than the underlying deterioration did.
  • An acceleration clause is the remedy: on an event of default the lender may declare the entire outstanding amount immediately due, rather than waiting for the schedule. Acceleration is what converts a repayment calendar into a single date.

The three consequences, in the order they bite

From a ratio crossing a line to a different-looking balance sheet
  1. 1
    The lender acquires a right and prices it

    In the great majority of cases nobody accelerates. The lender agrees to waive the breach, and takes something for the waiver: a higher spread, a fee, additional security, a promoter guarantee or infusion, a restriction on dividends and discretionary capital expenditure, a cash sweep directing surplus cash to prepayment. Each of those is a transfer of value away from equity holders, and each is disclosed somewhere.

  2. 2
    The accounts reclassify the loan

    A liability is presented as current unless the entity has the right, at the end of the reporting period, to defer settlement for at least twelve months after it. A breach on or before the reporting date that makes a long-term loan payable on demand removes that right, so the loan is presented within current liabilities — without a rupee having been demanded. An agreement reached by the reporting date, giving a grace period that ends at least twelve months after it, preserves the right and keeps the loan non-current. What a lender’s agreement reached after the reporting date does to the classification is a point to look up rather than remember: the answer differs between IFRS as written and Ind AS as notified in India, which carries a carve-out on precisely this question, and the treatment of covenants tested only after the reporting date has been amended more than once besides. The mechanism that does not move is the one to hold — classification is decided by what the company was entitled to on the reporting date — and where a company is relying on something the lender did later, it has to say so in the note. Read that note for this company and this year.

  3. 3
    Cross-default drags in the rest

    Once one facility is in default, the clauses in the others begin to operate on their own terms. This is why a company can move from a disclosed covenant breach on one loan to a general disclosure about the classification of substantially all borrowings within a single reporting period.

Worked example
The year nothing was borrowed
The manufacturer from the opening paragraph
Covenant in the facility agreementTested on 31 March each year and certified by the company to the lenderNet debt to EBITDA not above 3.5×
Prior year: EBITDA ₹800 cr, net debt ₹2,250 crComfortable, and nobody had thought about the clause in years2.81×
This year: EBITDA ₹600 cr, net debt ₹2,250 crBreached — on the denominator. Not one rupee of additional debt was raised3.75×
Position at the reporting dateNone by 31 March, and none by the date the board approved the accounts in May either. The waiver was signed in June, after the accounts had gone outBreach subsisting, no lender agreement of any kind
Non-current borrowings reclassified as currentPresented within current liabilities because the right to defer settlement did not exist on the reporting date₹2,150 cr
Current liabilities₹1,600 crore of ordinary current liabilities plus the ₹2,150 crore now sitting alongside them₹1,600 cr → ₹3,750 cr
Current ratio, on current assets of ₹1,900 crEvery liquidity ratio in every screener recalculates, and none of them is wrong1.19 → 0.51
The company that publishes these accounts is the company that published last year’s, with a quarter less operating profit. What changed is that a number crossed a line, and a set of contractual and presentational consequences followed automatically. Three things are worth taking from it. First, the covenant broke on the denominator: a leverage covenant is as much a bet on earnings holding up as on debt not rising, and a reader watching only the debt will not see it coming. Second, the reclassification is not a signal that the lender is about to demand the money — in this case it did not, and it granted a waiver ten weeks later. It is a signal that for a period the lender was entitled to, and the price of the waiver is the thing to go looking for in the notes. Third, the timing here decided the presentation with nothing left over: on 31 March the company had no right to defer, and it still had none when the accounts were approved in May. Had the lender signed in that window instead, the answer would have turned on which framework and which amendment applies to this company, which is a question for the accounting policy note rather than for a rule you carry around.

Where a reader can actually see them

  • The rating rationale. Agencies publish the sensitivities they will act on, and those thresholds are frequently the same numbers the lenders wrote into the agreements, because both were negotiated off the same analysis.
  • The notes to the accounts. A breach and any waiver have to be disclosed. Search the note text for "waiver", "breach", "not complied" and "covenant" before reading anything else in a leveraged company’s accounts.
  • The auditor’s report. An emphasis of matter paragraph, or a paragraph on material uncertainty relating to going concern, is the auditor telling you where the fragility is, in a document that is signed.
  • The debenture trustee. A company with listed debentures has a trustee acting for the holders, and the listing framework requires periodic filings on security cover and covenant compliance with the exchange. The required formats have changed more than once, so find the latest such filing rather than expecting a fixed document.
  • The offer document or information memorandum for a debenture issue, which summarises the covenants and the events of default in a way no annual report does.
◆ Recall practice

Five words that mean something specific

Cover the right column and say what each one entitles a lender to do.

Check yourself

A company breaches a leverage covenant at its 31 March testing date. The lender has agreed nothing by 31 March and nothing by the date the board approves the accounts in May; a written waiver follows in June. How is the loan presented in the balance sheet at 31 March, and what does that presentation mean?

Simple bhasha mein
Agreement ki woh line jo koi nahi padhta

Saal thoda kharab gaya: EBITDA ₹800 crore se ₹600 crore. Naya udhaar ek rupya nahi liya, net debt wahi ₹2,250 crore. Par agreement mein likha tha "3.5 guna se upar nahi" — aur ratio 2.81 se 3.75 ho gaya. 31 March ko bank se kuch tay nahi tha, aur May mein jab board ne accounts approve kiye tab bhi nahi — isliye ₹2,150 crore ka lamba karza kitaab mein current ban gaya: current liabilities ₹1,600 crore se ₹3,750 crore, current ratio 1.19 se 0.51, aur auditor ne paragraph joda. Cash ek rupya nahi hila. Waiver June mein aaya, accounts chhapne ke baad — ab dhoondho ki uske badle bank ne kya liya.

What to remember
  • A covenant breach usually produces a right the lender can trade rather than a demand for repayment.
  • The covenant is tested on the agreement’s definitions and dates, which are not the annual report’s.
  • A leverage covenant breaks on the denominator as easily as the numerator — falling profit trips it with no new borrowing.
  • A breach subsisting and unwaived at the reporting date moves the whole loan into current liabilities; what a later agreement does to that is a question for the accounting policy note, not for memory.
  • Find what the waiver cost — a wider spread, extra security, a suspended dividend — because it was not granted free.
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Common questions

Short, direct answers to what people ask about this topic.

debt covenant meaning
A debt covenant is a condition the borrower undertakes to maintain while a facility is outstanding — a maximum net debt to EBITDA, a minimum interest or debt service cover, a minimum security cover, a minimum promoter shareholding, no dividend above a stated payout. Breaching one is not failing to pay; it is failing to remain the borrower the lender agreed to lend to. The definitions are the agreement’s own and frequently differ from the published figures, so a company can comply while the ratio you compute from the annual report appears to breach.
a clause that treats a default under one loan as a default under another is called a
A cross-default clause. It is the transmission mechanism that turns one subsidiary’s problem, one lender’s facility or one missed certification into a group-wide event, and it is why distress in a large borrower moves far faster than the underlying deterioration did. The remedy that sits alongside it is acceleration — the lender’s right, on an event of default, to declare the entire outstanding amount immediately payable, compressing a repayment calendar into a single date.
what happens to the balance sheet when a loan covenant is breached
A long-term loan that a subsisting breach has made payable on demand is presented within current liabilities, because the company no longer held the right at the reporting date to defer settlement for at least twelve months. No cash moves and the lender need not have demanded anything, yet current liabilities swell and every liquidity ratio in every screener recalculates. What a lender’s agreement reached after the reporting date does to that classification is a question for the accounting policy note — Ind AS as notified in India carries a carve-out on precisely this point.
can a leverage covenant break without the company borrowing more
Yes — a leverage covenant is a ratio, so it breaks on the denominator as readily as the numerator. A company whose operating profit before depreciation falls from ₹800 crore to ₹600 crore while net debt stays at ₹2,250 crore moves from 2.81 times to 3.75 times and trips a 3.5 times limit without raising a rupee. A reader watching only the debt figure will not see it coming.
where can I find out if a company has breached a loan covenant
In the notes to the accounts first — a breach and any waiver must be disclosed, so search the note text for covenant, breach, waiver and not complied before reading anything else in a leveraged company’s accounts. Then the auditor’s report, for an emphasis of matter or a material uncertainty relating to going concern; the rating rationale, for the sensitivities the agency has said it will act on; and, where debentures are listed, the debenture trustee filings made to the exchange on security cover and covenant compliance. The offer document for a debenture issue sets out the covenants and events of default in a way no annual report does.