Covenant Breach and the Refinancing Decision
Tembo Agro Ltd has a KES 60 million term loan at 14% fixed, repayable in equal annual instalments of KES 15 million over four years. Its loan covenant requires a debt service coverage ratio (DSCR) of at least 1.25. In the current year, EBITDA is KES 18 million, depreciation KES 4 million, interest KES 8.4 million, and tax KES 1.2 million. The next instalment of KES 15 million falls due in 30 days. The bank has offered to refinance at 16% floating with a five-year term, lowering annual instalments to KES 12 million, but adding a 2% arrangement fee on the outstanding balance of KES 45 million. The finance director wants to accept immediately to 'solve the covenant problem'.
1. Compute the DSCR and determine whether the covenant is breached.
Read the worked answer
DSCR = Cash available for debt service ÷ Debt service
Cash available for debt service (typically EBITDA less tax, or operating cash flow before interest and principal):
- EBITDA = 18.0
- Less tax paid = (1.2)
- Cash available = 16.8
Debt service = interest + principal = 8.4 + 15.0 = 23.4
DSCR = 16.8 ÷ 23.4 = 0.72
The covenant of 1.25 is badly breached (0.72 vs 1.25). Even using EBITDA alone (18.0 ÷ 23.4 = 0.77) the position fails. The company cannot service the current debt from operating cash flow and needs either refinancing or an equity injection.
2. Evaluate whether the refinancing offer genuinely resolves the problem, quantifying the cost, and recommend a course of action.
Read the worked answer
Quantifying the refinance:
- Arrangement fee = 2% × 45m = KES 0.9m (cash cost, likely capitalised and amortised).
- New annual instalment = 12m principal-equivalent; interest at 16% on declining balance - higher rate.
- New DSCR (approx, ignoring fee amortisation): cash available 16.8 ÷ (interest ~7.2 + principal 12) = 16.8 ÷ 19.2 = 0.875 - still below 1.25.
Judgement: Refinancing lowers the instalment and eases liquidity but does not restore the covenant - DSCR remains under 1.25. It also raises the interest rate (14% → 16%) and adds a KES 0.9m fee. Accepting 'immediately' treats a symptom, not the cause: weak operating cash flow.
Recommendation:
- Do not sign without a covenant reset - negotiate a DSCR waiver or a revised threshold for 12–24 months.
- Address the underlying EBITDA gap: review pricing, receivables collection, and working capital.
- Consider a partial equity injection to reduce principal.
- Model sensitivity to the floating rate - a rate rise further erodes DSCR.