The covenant trap: nothing has changed in the business, and the bank is asking questions

Your cash flow has not changed by a penny. So why is your bank asking questions?

This follows the previous piece on the balance sheet shock. Here is where it becomes commercially dangerous.

When lease liabilities land on the balance sheet, two things happen at once.

Gearing rises. New debt divided by the same equity gives higher leverage. A company running at 1.5 times gearing could find itself at 2.5 times or more, depending on its lease exposure.

EBITDA rises too, and the rise is misleading. The rent expense leaves operating costs. In its place come depreciation of the right-of-use asset (paragraph 20.56) and interest on the lease liability (paragraph 20.64). Neither touches EBITDA, so reported EBITDA goes up while the underlying business is exactly as it was.

The trap is that most loan agreements were written under the old rules. A maximum leverage ratio of three times made sense when leases were invisible. Under the new Section 20, a covenant can be breached by an accounting reclassification alone, with no change in trading and no change in cash.

Some facility agreements include a "frozen GAAP" clause, under which covenants continue to be tested on the accounting rules in force when the agreement was signed. Many do not, and the ones that do still need the figures prepared both ways.

The fix is not complicated, but it is urgent. Model the effect now and speak to the lender before the next reporting date. Renegotiating a covenant definition in advance is routine. Explaining a technical default after the fact is not.

The next piece covers why a spreadsheet is the wrong place to run this.