Covenant Pressure and FX Hedging Decision
Kelani Engineering Group PLC reports in Sri Lankan rupees. For FY2025, EBITDA is LKR 9.6 billion and net debt is LKR 36.5 billion, giving net debt/EBITDA of 3.8x against a bank covenant of 3.5x. The group has a USD 25 million term loan at compounded SOFR plus 3.25%, repayable in 2027, and expects USD 18 million of export receipts over the next 12 months. About 30% of revenue is USD-linked. The rupee has moved from 290 to 305 per USD in three months. Treasury proposes either hedging 70% of the next 12 months' USD exposure with a 12-month forward at 312, or doing nothing because 'the rupee always depreciates'. Interest cover is 2.9x. The CFO wants to know the cost of the forward, the effect on covenant headroom, and whether SLFRS 9 hedge accounting would reduce reported volatility. The audit committee has asked whether a going-concern disclosure is needed.
1. Quantify the forward premium and assess whether hedging 70% of the exposure is appropriate. Compare the forward with the board's budget rate of 300.
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Forward premium. (312 - 305) / 305 = 2.30% over twelve months. The forward is not a fee; it is the market's reflection of the interest-rate differential between LKR and USD, plus a liquidity margin. The relevant comparison is with the budget rate and with the risk the board is willing to bear, not with a forecast spot rate.
Hedged amount. 70% of USD 18m = USD 12.6m. At 312, receipts are LKR 3,931m. At the budget rate of 300 they would be LKR 3,780m, so the forward locks in LKR 151m above budget. Against spot of 305, the forward gives LKR 88m more; if spot moves to 330, the forward gives LKR 227m less. The forward protects the downside but forgoes the upside.
Is 70% appropriate? The exposure is not just the USD 18m of receipts; there is also USD 25m of debt and interest. A hedge ratio should be set against net exposure and debt-service cover. Hedging 70% of receipts is defensible if the board's policy is to cover at least debt service and budgeted margin. It is not defensible if it is an arbitrary number. Treasury should present a policy range, for example 50-80%, and link it to the minimum LKR receipts needed for interest and covenant compliance.
Conclusion: the forward costs about 2.3% annualised against spot; the decision should be driven by a documented hedging policy, not by a view that the rupee 'always depreciates'.
2. Analyse the covenant position, including the effect of a further 10% rupee depreciation, and recommend actions.
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Current position. Net debt LKR 36.5bn / EBITDA LKR 9.6bn = 3.80x against a 3.5x covenant. To reach 3.5x, EBITDA must rise to LKR 10.43bn (an increase of LKR 0.83bn), or net debt must fall to LKR 33.6bn (a reduction of LKR 2.9bn). Neither is achievable through ordinary trading alone in the short term. Interest cover of 2.9x is also thin.
Effect of 10% depreciation. From 305 to about 335.5. The USD 25m loan increases by roughly LKR 762m, taking net debt to about LKR 37.3bn and the ratio to about 3.88x. The unhedged USD 18m of receipts gains about LKR 549m, which helps cash but not EBITDA. Hedging part of the receipts would reduce that natural offset, which is the cost of certainty.
Actions: suspend the dividend; pursue a sale-and-leaseback of non-core property; seek an equity injection from the parent; refinance or extend the USD loan; negotiate a covenant waiver or reset with the bank before the testing date; and reduce capex. Hedging does not improve the covenant ratio in accounting terms, although it stabilises cash flow.
Going concern: a breach does not by itself mean going concern fails, but the audit committee needs a cash-flow forecast covering at least twelve months, evidence of bank support and a credible cure plan. Disclosure should be considered if material uncertainty exists.
3. Explain whether cash flow hedge accounting under SLFRS 9 is available and what the group must document.
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Availability. Cash flow hedge accounting is available if the group hedges the variability in cash flows from highly probable forecast USD export receipts. The forward is an eligible hedging instrument and the receipts are an eligible hedged item, provided they are separately identifiable and reliably measurable. The group can designate the spot element as the hedge and record the forward points as a cost of hedging in other comprehensive income, or designate the full forward.
Documentation required at inception:
- The risk management objective and strategy, including why the group is hedging and the hedge ratio.
- Identification of the hedging instrument, the hedged item and the nature of the risk.
- An assessment of whether the economic relationship between the two is expected to be effective, including the possibility of a credit valuation adjustment.
- The method for measuring ineffectiveness.
Accounting outcome. The effective portion of the forward's fair value change goes to OCI and is recycled to profit or loss when the receipts affect profit. Ineffectiveness goes to profit or loss. Without hedge accounting, the whole fair value change hits profit or loss each period, creating volatility that may alarm lenders even though the economics are hedged.
Caveat. Hedge accounting does not change cash flows or the covenant calculation. It changes presentation and timing. The group should not use it to obscure an economic exposure that the board has not actually decided to hedge.