Currency risk on financial covenants

One of the main constraints on CFOs are financial covenants, the most important of which is undoubtedly the ratio of (net) debt to EBITDA, known as leverage. If it falters or weakens, it can impact a company's rating and increase its total cost of financing. It is therefore important to measure this risk, monitor it and consider mitigating it, when necessary or when the situation of this ratio is tense and very close to the limit imposed by creditors. Let's look at how to deal with it, and whether effective solutions exist.

Leverage, often a key financial ratio to monitor

One of the most important corporate constraints is the famous “financial leverage”, commonly defined as total debt on EBITDA or even net debt on EBITDA. It is essential as it may impact a company’s credit rating, cost of funding and sometimes is also explicitly restricted by loan documentation and financial covenants to not exceed a certain level. There are three main ways, this leverage ratio can be endangered. The denominator, EBITDA, drops because of weaker business than originally envisaged. Then, if the debt rises due to higher funding needs. Eventually, the third way, which is interesting for us here, has not to do with the business performances but with the context of currency risk. If a significant part of the EBITDA is reported in foreign currency, it may fall, even though the underlying business is doing well, purely because of depreciation of the foreign currencies against the reporting currency. And, similarly, if part of the debt is in foreign currency, the overall debt will be impacted by currency fluctuations. This type of risk can be hedged against by matching the debt and assets by currency. Usually, debt in currencies doesn’t perfectly match the EBITDA contribution in currencies. From this possible mismatch, weaker currencies can impact EBITDA down and/or stronger currencies of debt, can make it all-on bigger and impact the net ratio. With companies having a small margin of maneuver it can be tricky. A small currency move can alter the ratio and put them into trouble with credit rating agencies or/and lenders. In general, what a treasurer will try to do is to match his/her free cash-flows in currencies to the debt reimbursements in currencies.

Ways to calculate exchange rates used under consolidation under IFRS rules

One element that can cause problem is the way the rates used are calculated for these leverage ratio components. Debt is normally computed at the spot exchange rate at the end of the period, while EBITDA is computed at the average rate during the period. This discrepancy can cause problems with the leverage covenants as the move of denominator and numerator may be different, even when debt and EBITDA are aligned to mitigate risks. It is more complicate than it appears to be properly hedged. Many factors can jeopardize the covenants (not only the debt to EBITDA).

Objectives and solutions, if any

The company objectives are to find solution to protect leverage against rapid moves of some currencies of the EBITDA, to ensure that the timing of payments and reference rates are as close as possible at the end of the period, and to guarantee that accounting treatment is advantageous to the group. The solution resides in way to structure derivatives to pay the difference between the two rates used (if positive) and for the company to pay the delta to the bank, if negative.

There are three types of OTC derivative products, the company could contemplate. The first one is an average strike call (for which a premium must be paid). It means a sum of money to be received at the end of the period in case the average rate is higher than the closing rate. It would give a full protection and enable to even improve the ratio with no limit on the downside. It requires a premium payment as a downside. The second one, would be an average strike collar, therefore with no or limited cost. You sell a third currency put and functional currency call to mitigate part of the premium attached to the call, in foreign currency. As a zero-cost solution, it protects without giving opportunities to benefit from upsides (if any). Eventually, the third one can be an average strike forward, where you sell the third-party currency and buy the functional currency at the monthly average rate. This last solution gives a full protection at zero cost but involves potentially negative cashflows. With 2 currencies it is rather simple. With many, it can become complex. Hedging may be contemplated if you are sensitive to covenants and unable to renegotiate them. The sudden movements at year end can be disastrous. Rin reality, rating agencies have a longer-term view of leverage efforts and do not consider short-term sub-normal movements. We saw how compliance with a leverage covenant can be endangered by the rapid devaluation of one currency. Finally, we should never forget that a non-hedge accounting solution should never be preferred to a hedge accounting one (at equivalent results). The complexity here can be such that again a dedicated tool may be necessary to assess the situation and calculate risks. We encourage Currency Management Automation (CMA) Solution, likely not for this specific strategy, but for other repetitive ones to release treasurers from heavy and repetitive tasks. The good news is that these solutions, such as KANTOX, exist and work perfectly well. There are no excuses for not fully automating the FX processes from pre-trade to execution until post-trade processes; By freeing time, treasurers can become more strategic (like fort managing such covenants) and business be better protected.

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Fran?ois Masquelier, CEO of Simply Treasury – Luxembourg December 2023

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Disclaimer: This article was prepared by Fran?ois Masquelier in his personal capacity. The opinion expressed in this article are the author’s own and do not necessarily reflect the view of the European Association of Corporate Treasurers (i.e., EACT).