capital-structure-and-covenants

Capital structure and covenants

Financing is not only where the money comes from. It is a set of ongoing constraints that will

shape operating decisions for as long as the facility exists, and most of those constraints are

discovered late.

Cost of capital sets the hurdle, so compute it rather than choosing a round number

Weighted average cost of capital blends the after-tax cost of debt and the cost of equity in the

proportions actually used. It is the rate an investment has to clear before it creates value.

Debt is cheaper than equity — the rate is lower, the interest is deductible, and the claim is

senior. That cheapness is exactly why leverage is tempting, and why the temptation needs a limit

set in advance. Equity has a cost even though nobody writes a check for it; treating it as free

is how capital gets consumed by projects that never earned their keep.

Size leverage to the bad case, not the plan

Leverage amplifies returns on equity and amplifies losses, and the losses arrive first because debt

service does not wait for recovery.

Capacity is governed by the stability of cash flow, not by an industry average ratio. A predictable

subscription business carries debt that a project business with lumpy collections cannot. The

question is never "can we service this at plan" — it is "can we service this at the plan we would

be embarrassed to show anyone."

Covenants are where financing becomes an operating constraint

• Financial covenants — leverage ratio, interest coverage, fixed charge coverage, minimum

liquidity, sometimes a minimum earnings floor. Tested quarterly in most agreements.

• Affirmative covenants — what you must do: reporting by a deadline, audited statements,

insurance, notice of material events.

• Negative covenants — what you may not do without consent: additional debt, liens, asset

sales, distributions, acquisitions, change of control.

The definitions matter more than the levels. Earnings in a credit agreement is a defined term

with its own permitted add-backs and its own caps, and it will not equal the figure in your

management accounts. Two facilities at the same headline ratio can allow very different behavior.

Model covenants forward at every material decision. A hiring plan, a capex commitment, or an

acquisition can trip a ratio two quarters out while looking affordable this quarter. Headroom at

each future test date belongs in the forecast, not in a separate spreadsheet nobody opens.

When a breach is coming, the timing of the conversation is the whole outcome

Approach the lender before the test date. A waiver requested in advance is a negotiation; a breach

discovered afterward is a default, and the difference in leverage between those two positions is

enormous.

Know what the agreement gives you before you need it: cure periods, grace periods, whether an

equity cure is permitted and how often, and whether cross-default provisions pull other agreements

in behind this one. Consequences escalate rather than arriving all at once — a fee, then a rate

step-up, then tightened covenants, then a cash sweep, then acceleration.

Never

• Sign a facility without modeling its covenants against the downside case.
• Read a covenant level without reading the definitions it depends on.
• Arrive at a test date without already knowing the number.
• Treat equity as costless because no payment leaves the account.