Kestrel Manufacturing: A Covenant Waiver That Expires Before the Next Test

The going concern assessment period runs at least 12 months from the date the financial statements are approved - roughly to March 2027 - not to the next covenant test.

The waiver covers only to 31 March 2026. It is three months long and expires before the audit report is signed. Two consequences follow. First, under IAS 1 the breach at 31 December 2025 gives the lender a right to demand repayment; the liability is classified as current unless a grace period ending at least 12 months after the reporting date was agreed before the end of the reporting period. A waiver to 31 March 2026 does not meet that test, so the term loan must be presented as current unless a further waiver is agreed.

Second, the arithmetic shows how thin the position is. To meet 3.5x with net debt of £34.0m, EBITDA must be at least 34.0 / 3.5 = £9.71m. Actual EBITDA is £9.2m - a shortfall of £0.51m, roughly 5.5%. Even if the £6m contract is signed, at an 18% gross margin it adds about £1.08m of gross profit spread over delivery; very little of that lands in the twelve months to 31 March 2026, and the covenant is measured on trailing EBITDA at that date. The forecast's £0.4m headroom is smaller than a single month's variance and depends on a contract that does not yet exist and on a 22% receivable that may be impaired - an impairment would reduce EBITDA and, in a going concern stress case, could not be ignored.

The going concern basis may still be appropriate if the April refinancing is genuinely probable and disclosures are full. But a material uncertainty exists: the waiver expiry, the unmitigated breach on 31 March and the reliance on an unsigned contract mean the events are significant and the response is not fully within management's control.

Over the contract: obtain the draft, all versions and the legal review correspondence; read it for conditions precedent, financing or performance bonds, and cancellation rights; confirm directly with the customer that terms are agreed and the timing of signature; interview commercial staff about the probability of close; and check whether the gross margin assumption of 18% is consistent with similar contracts. Do not accept management's probability assertion without corroboration - an inquiry of the customer is the strongest evidence.

Over the covenant: obtain the executed waiver and confirm it directly with the bank; re-compute net debt and EBITDA from the underlying ledgers, checking the definition in the facility agreement (which may add back or deduct items management has excluded); obtain the bank's written position on the March test and on the April refinancing; obtain the term sheet, board approvals and lender correspondence for the refinancing; perform sensitivity analysis on EBITDA, receivable collection and contract timing; and obtain written representations covering the completeness of covenant information.

If the contract is unsigned at the report date: remove it from the forecast and re-run the model. The 31 March test will be breached on the numbers, and the refinancing is not agreed. That is a material uncertainty whose outcome is not dependent only on management's plans. If management's disclosures describe this fully and the basis remains appropriate, issue an unmodified opinion with a Material Uncertainty Related to Going Concern section. If the disclosures understate the position, the opinion must be qualified or adverse under ISA 570. If you cannot obtain sufficient evidence about the bank's intentions or the refinancing, a qualification or disclaimer of opinion on that limitation is the alternative - the auditor cannot default to the unmodified report because a paragraph would be commercially inconvenient.

In the financial statements: the loan is presented as current under IAS 1 unless a 12-month grace period exists; the breach, the waiver and its expiry are disclosed; and the going concern disclosure sets out the material uncertainty, the basis for believing the refinancing is achievable, the sensitivity to the unsigned contract and the consequence of failure. The disclosure must be specific - the covenant figure, the required EBITDA and the waiver dates - not a generic 'the group depends on future funding' sentence.

In the auditor's report: an unmodified opinion with a Material Uncertainty Related to Going Concern section immediately after the Basis for Opinion, cross-referring to the disclosure, unless the matter is properly a Key Audit Matter only where no material uncertainty exists. Where a separate section is used, the going concern matter is typically reported there rather than duplicated as a KAM. If disclosure is inadequate, ISA 570 requires a qualified or adverse opinion.

The finance director's objection: the threat that a paragraph 'kills the refinancing' is a pressure tactic and must be recognised as such. Reporting is not a marketing instrument. The response is to explain that lenders price uncertainty, and that a report that conceals a covenant breach carries far greater refinancing and litigation risk than a clearly labelled material uncertainty. Record the conversation, inform those charged with governance of the pressure, and make clear the opinion will reflect the evidence, not the negotiating calendar. The auditor's duty runs to the users of the accounts.