Loan Covenants: Calculations and Breach Evidence

What a Loan Covenant Requires

The facility documents determine the covenant and who must comply with it. A financial covenant tests a defined measure against a threshold. Other undertakings can require financial reporting, timely payments or consent before particular conduct.

Start with the executed facility and identify its borrower, guarantors and lender or facility agent. Record each amendment and the particular obligation under review. A guarantor’s undertaking can differ from the borrower’s, even where both documents concern the same funding.

A missed repayment concerns a payment obligation. A failed coverage ratio concerns a financial test. Evidence that instalments were paid does not establish compliance with every financial covenant. Equally, a failed financial test does not prove that an instalment was missed.

Identify the facility’s governing law before applying legal authorities. For Australian commercial contracts, Mount Bruce Mining v Wright Prospecting explains objective construction by reference to contractual text, context and purpose. A familiar ratio name cannot replace the wording the parties agreed.

Extract the Agreed Test Before Using the Accounts

Prepare a test sheet that another accountant can follow without guessing which definition you used. Read the operative documents before copying figures from the accounts.

1. Identify the covenant clause and every definition it incorporates. Record the executed document and any effective variation beside each provision.
2. Copy the defined numerator and denominator. State which earnings, cash amounts or debt obligations each includes, with the treatment of exceptional items.
3. Identify the tested entity or group. Record subsidiaries included, consolidation requirements and any intercompany eliminations.
4. Record the measurement event and testing period. A balance at a particular point differs from activity over a rolling twelve-month period.
5. Record the threshold and comparison direction. Preserve any rounding convention and the units required for the inputs.
6. Identify the accounting basis and permitted adjustments. Record consent requirements, restrictions on cash and the scope of debt separately.
7. Record the reporting deadline and required certificate. A deadline for delivering accounts can fall after the event at which the financial test is measured.

Keep a proposed amendment outside the operative calculation until its effectiveness is established. A lender’s discussion of revised terms does not itself establish that those terms govern the test.

For example, an agreement might exclude restricted cash from a debt-netting calculation. Copying the total cash balance from the accounts would then use a different input. A change in accounting treatment also needs comparison with any fixed accounting basis in the facility.

Tie Each Input to Its Source Record

Give every calculation input a source reference and a reconciliation. Record the entity, period and currency, including whether the source presents whole dollars or thousands.

Use the accounts as the starting record where the contractual definition calls for accounting figures. Trace adjustments through the ledger and supporting schedules. Wider financial statement analysis can resolve the accounting treatment behind a disputed component.

For the cash-side check, reconcile opening balances, advances and repayments to closing balances. Match the loan schedule with bank entries and identify timing differences, capitalised interest or charges supported by the records. A transfer between accounts needs both sides identified before it is treated as an external receipt or payment.

Bank movements establish cash activity. They cannot substitute for accrual earnings or determine which liabilities the agreement includes as debt. Use the relevant lending balance as an input. Where shareholder funding affects that balance, examine the shareholder loan agreement and its performance records.

An adjustment schedule must explain the amount and the clause permitting its treatment. If consent is required, retain the consent relied on. Mark an unsupported adjustment separately and show the result without it. For missing evidence, identify the needed ledger extract, statement period or signed document. A missing amount remains unresolved instead of becoming zero.

Reproduce the Calculation and Compare Disputed Treatments

The following coverage covenant is entirely fictional. Its stated terms require a ratio of at least 1.25 for the borrower alone over the preceding twelve months. The numerator is the earnings amount defined in its fictional schedule, plus exceptional-cost adjustments approved in writing by the lender. The denominator is the schedule’s defined debt-service amount for the same period. These definitions belong only to this example.

The fictional earnings schedule E1 supports $450,000 before the disputed adjustment. The borrower’s certificate C1 adds $150,000 for an exceptional cost, producing a reported numerator of $600,000. Debt-service schedule D1 supports a denominator of $400,000. The fictional file contains no written lender approval for that adjustment. The example’s terms require comparison of the unrounded result with the minimum.

The reported calculation has headroom of 0.25 ratio points because 1.50 minus 1.25 equals 0.25. Removing $150,000 gives $450,000 divided by $400,000, or exactly 1.125. That unrounded result is below 1.25.

Under these fictional terms, the file supports exclusion of the adjustment unless the required written approval is established. Reproducing the certificate’s arithmetic alone would miss the issue. If an actual facility specifies rounding or different adjustment rules, apply those provisions before recording its result. Neither this formula nor 1.25 is a universal covenant standard.

Separate a Failed Test From the Contractual Consequence

Trace a failed financial test through the provisions that govern reporting and default. Record whether the failure itself is an event of default or whether another condition must occur.

Follow the facility’s sequence. Identify any reporting obligation, required notice and available cure process. Check who has authority to send a notice, who must receive it and how delivery is established. If a cure period applies, record its trigger and whether the permitted action occurred within it. Some obligations can take effect without a prior notice, so read the particular provision.

Keep an equity-cure right separate from its exercise. Retain evidence of the contribution and test whether its amount, timing and treatment meet the clause. A promise to contribute funds is a different record from money received under the required conditions.

A waiver directed to one test result must be read for its scope. A permanent variation changes the operative terms when effective. In Agricultural and Rural Finance v Gardiner, the High Court examined the legal basis of an asserted waiver and rejected the borrower’s arguments. Calling correspondence a waiver does not resolve its effect.

Acceleration needs analysis of the repayment provision and any required election or notice. Security enforcement requires the security terms and applicable law to be considered separately. Read the general security agreement where relevant, and examine any cross-default provision in the other facility before asserting a wider default.

A failed ratio alone establishes neither insolvency nor misconduct. Renegotiation is a separate decision about the funding arrangements. If the result prompts a workout assessment, corporate debt restructuring addresses the creditor and repayment questions that follow.

Verify and Hand Over the Compliance Record

The compliance record must let the responsible accountant reproduce the financial finding and the instructed lawyer assess its contractual effect. Finish the review against this checklist.

• Retain the executed wording, incorporated definitions and effective amendments, with the governing law identified.
• Confirm the tested entity, period and units match every input and supporting schedule.
• Reconcile the inputs and show the arithmetic, including the unrounded result and any contractual rounding.
• Explain each permitted adjustment and retain any required consent, with contrary evidence and alternative calculations visible.
• Identify the authorised signatory and retain any compliance certificate, including the calculation it certifies.
• Attach the notices, delivery evidence and any cure, waiver or amendment relied on. Record unresolved construction questions for legal advice.

For statement-heavy reviews, FinTrace saves forensic accountants hours of monotonous conversion and cash-side analysis. The service turns supplied bank-statement PDFs into a categorised Excel workbook and source-cited findings. Each finding identifies its PDF filename and page, putting the supporting cash evidence at hand for the covenant review.

The accountant applies the contractual definitions and accounting adjustments to the reconciled figures. The instructed lawyer addresses construction and rights, while certification stays with the responsible authorised professional. Hand over the calculation alongside its contrary evidence and unresolved questions so each conclusion can be traced to the work that supports it.