Published: June 15, 2009
The financial markets tumult has left many corporates facing a series of challenging decisions; arguably none more so than the negotiation of funding or the maintenance of existing credit lines. With recent reports highlighting the onset of tighter financial covenants, to what extent will financial covenant ratios be impacted by the increased market volatility?
International Financial Reporting Standards requires all derivatives to be fair valued through the income statement
It can be argued that a financial covenant’s primary role is to forewarn the onset of financial difficulty - the latter often appearing in the form of an unmanageable exposure to risk. The flagging of a potential breach allows action to be taken by both lender and borrower to address the issue.
Ratio analysis is the most common method of policing the covenant - an area customised to accord both the lender’s and borrower’s requirements. Examples of financial covenant ratio categories are:
These ratios serve well in times of low market volatility (as the underlying business and degree of market risk accepted are the primary drivers of change). In times of high volatility, however, the following ratios in particular, bear a significant exposure to market risk reporting that is fair value / quasi fair value change:
In each case, the numerator and the denominator has the potential to be impacted.
The first section of this article assesses the extent to which this might be an issue by comparing the degree of recent market volatility to prior periods. The second makes use of a case study to compare the potential 2007 and 2008 reporting period. Actual market volatility has been applied to the latter.
Euro
Figure 1 of Appendix B demonstrates the unprecedented quantum and speed of Sterling’s depreciation against the Euro during 2007 / 2008; a 42% decline between June 2007 and December 2008. The next recorded depreciation of this magnitude occurred in the 2nd quarter 2003, a mere 15%.
The average exchange rate fell 17% from 2007 to 2008, the largest movement on record.
US Dollar
In 2007/2008, Sterling depreciated by approximately 27% against the US dollar (refer Figure 2 in Appendix B); the last time an equivalent depreciation was recorded was at the beginning of 1994.
The average exchange rate fell by 8% from 2007 to 2008 - following on from an 8% appreciation in average sterling value from 2006 to 2007. [[[PAGE]]]
Over the 18 month period ending 31 December 2008, the GBP 3 year swap rate fell by 54% (Appendix B, Figure 3), the EUR 3 year swap rate by 38% (Appendix B, Figure 4) and the USD 3 year swap rate by 68% (Appendix B, Figure 5) - which in the case of USD and EUR, were levels not seen since 2003.
A GBP interest rate swap traded on 30 June 2006 and 30 June 2008 respectively would have the following fair value at 31 December 2006 and 31 December 2008 (see Table 2).
Ignoring the elasticity issue arising from the different fixed rates at each time period, 10 times more volatility was experienced in 2008 than in 2006.
Over the 18 month period ending 31 December 2008, crude oil fell by 37% (refer Appendix B, Figure 6) and copper by 61% (Appendix B, Figure 7).
More particularly, crude oil, in the 18 months ended 30 June 2008, increased by 129% and thereafter declined by 68%.
A gas oil swap traded on 30 June 2006 and 30 June 2008 respectively would have the following fair value at 31 December 2006 and 31 December 2008 (see Table 3).
Although it is acknowledged that the above market volatility could manifest itself within financial statements in a variety of different forms (e.g. employee benefits, provisions, etc.), the primary focus of the next section will be the reporting of derivatives, translating and hedging foreign subsidiaries. [[[PAGE]]]
An entity is required, in most circumstances, to translate their foreign operations into the group’s presentation currency for consolidation purposes. Assets and liabilities within the foreign operation are translated at the closing rate of the balance sheet; income and expenses at the date of each transaction (practically, an average exchange rate is used for the reporting period). The resulting exchange differences are reported in equity.
The net investment in a foreign operation3 may be hedged by either a derivative (for example, a cross-currency swap between the foreign operation’s functional currency and the Group’s presentation currency) or non-derivative instrument (loan in the foreign operation’s functional currency). The effective portion of a hedge of a net investment must be recognised in equity and only transferred to the income statement upon disposal of the foreign operation.
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There are three points to investigate - all have a bearing on the translation and transaction risk associated with the acquisition and funding of SubCo:
With reference to the Case Study opposite. Initially, SubCo is entirely funded by a Euro loan in HoldCo (€24,000) and a zero net profit is reported in both HoldCo and SubCo’s 2007 and 2008 Annual Financial Statements.
The Euro liability would increase in Sterling terms from £16,169 to £22,942 between 2006 and 2008 - a jump of 42%.
The impact on the Debt to Equity ratio and Total Debt/ Total Asset would therefore be as follows:
2007 2008
Debt to Equity Ratio 55% 68%
Total Debt / 0.45 0.49
Total Asset
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The Total Debt/Total Asset ratio has changed marginally for the following reasons:
1. It is assumed that the original Total Debt/Total Asset ratio is not equal to 1.
2. The absolute change in the Total Debt/Total Asset figure due to translation will be the same[4].
3. The new ratio will be the sensitivity of the old ratio to the new absolute translation figure.
Next, assume that Û14,000 was funded in Euros - the remainder in Sterling at acquisition.
As expected, the impact on the Debt to Equity ratio and Total Debt/ Total Asset would be less volatile:
2007 2008
Debt to Equity Ratio 53% 61%
Total Debt / 0.45 0.48
Total Assets
The change in currency funding impacts both the numerator and denominator of the Debt to Equity ratio in a positive manner; the former by the change in the amount of debt translated into Sterling and the latter by the reduction in the hedge of the net investment i.e. an increase in equity.
A Group that funds (and therefore hedges) only part of their foreign operation in its functional currency would report a substantially better Debt to Equity ratio and a marginally better Total Debt / Total Asset ratio than an entity funding the entire purchase in the functional currency of the foreign operation.
The impact of SubCo’s net profit on EBIT- SubCo fully funded in euros and used as a hedge of a net investment
If a constant net profit was earned during both 2007 and 2008 (and assuming that SubCo generated in Sterling terms approximately 25% of the Group’s EBIT), the effect on the Debt to EBIT would be as follows:
2007 2008
Debt to EBIT 3.14 3.74
The Debt to EBIT ratio is affected by two opposing, but unequal factors:
1. The (relatively small) impact of the positive average exchange rate bias on SubCo’s EBIT and
2. The increase in the Euro liability position in Sterling terms. [[[PAGE]]]
Full Euro funding, but no hedge of a net investment
Staying with the last example i.e. full Euro funding and constant net profit after tax, assume that the former is translated through the Income Statement (and that EBIT is impacted). The debt to EBIT ratio would be as follows:
2007 2008
Debt to EBIT 3.71 12.02
The magnitude of the volatility demonstrates, in this case, both the potential impact of exchange rates on the Financial Statements and the importance of the correct accounting election.
Financial Covenant Volatility: an Indication of Real or Fictitious Risk?Isolating only the translation / foreign exchange transaction risk, the question of whether this is a real or fictitious risk would depend on the presence and extent of either:
If neither is available, the case study’s Euro funding (at the spot Euro/ Sterling exchange rate) would be repaid out of Sterling cash flows. The currency volatility could therefore be seen as real risk.
International Financial Reporting Standards requires all derivatives to be fair valued through the income statement.[5] Although there is variation in practice, a corporate not performing hedge accounting might include this volatility within their earnings before interest and tax figure (EBIT).
Derivatives purchased on 30 June 2008 (using the terms in Table 2, but applied to the case study i.e. 100% of the Sterling loan in HoldCo and 100% of the Euro loan in SubCo) would report a reduced EBIT of £1,425 and an increased liability position at 31 December 2008.
Assuming the acquisition of SubCo was fully funded in Euros, the Debt to EBIT ratio would be impacted as follows: -
2008 - no 2008 - with
derivative derivative
Debt to EBIT 3.74 4.31
The change in the Debt to EBIT ratio reflects the full market risk of the swaps on the income statement for that period. [[[PAGE]]]
If an entity is unable or unwilling to accept this volatility, IAS 39 provides an “exception” in the form of hedge accounting - more specifically for the purposes of this case study, cash flow hedge accounting.[6]
An example of a qualifying cash flow hedge relationship might be the combination of the gas oil swap described earlier and a series of similarly timed highly probable forecast gas oil purchases (or equivalent - to the extent highly correlated). Likewise a floating rate loan may be hedged with a receive floating / pay fixed interest rate swap within a cash flow hedge relationship.
A qualifying and effective cash flow hedge relationship would allow the entity to transfer the cumulative 100% hedged or under-hedged position to a separate component of equity - assume in this case that the full £1,425 would be transferred.
Assuming the acquisition of SubCo was fully funded in Euros, the balance sheet ratios would be impacted as follows: -
2008 - no 2008 - with
derivative CashFlow
hedge
Debt to Equity 68% 70%
Ratio
Total Debt / 0.49 0.50
Total Asset
The change in the Debt to Equity ratio is affected by the Equity adjustment, the Total Debt/Total Asset ratio by the change in debt.
Again, is this volatility fictitious? That part of the cash flow hedge apportioned to equity would be difficult to argue otherwise. A cash flow hedge by definition is reducing exposure to the hedged risk. Whether this was an optimal or sub-optimal hedge would be reflected in the income statement as a reduction or increase to an individual line item e.g. an increase in interest expense in the case highlighted above.
A non hedge accounted derivative is more contentious. An entity may decide not to perform hedge accounting on a risk-reducing derivative for a variety of reasons e.g. administrative issues (particularly when there is a large quantum of derivative hedging performed) or the derivative (in its entirety or component part) does not adhere to the strict requirements within IFRS. The inclusion or otherwise of this volatility will form part of the financial covenant negotiation between borrower and lender.
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ConclusionMarket analysis performed in the last six months indicates a tightening of covenants during the credit crunch era - an understandable manifestation of current market conditions. The natural implication is that a cash flow exposure to market risk will become increasingly important; concomitant with defined hedging strategies.
This article focuses on two specific areas where pre-defined financial covenants may experience volatility in the current climate - translation of monetary items / foreign operations to the presentation currency and derivative accounting (with particular emphasis on cash flow hedge accounting).
In each, the extent of the exposure to market risk requires assessment - and the usefulness of the covenant to identify this risk in a timely manner. In assessing the latter, the source, nature and timing of cash flows will be key to the negotiation.
Should you wish to find out more on this topic or potential hedging strategies to actively manage covenant risk, please do not hesitate to contact a Commerzbank Corporate Sales representative.
The views expressed in this article are those of the author and do not necessarily reflect the views or policies of the Commerzbank Group, or its Board of Directors.
1 Financial Ratios and Credit Risk: The Selection of financial ratio Covenants in Debt Contracts; Peter R.W.Demerjian
2 Functional currency is defined in IAS 21 as the currency of the primary economic environment in which the entity operates.
Presentation currency is the currency in which the financial statements are presented.
3 IAS 21 para 8 - defined as the amount of the reporting entity’s interest in the net assets of that operation
4 Purchase Price = Balance Sheet of SubCo + Goodwill. All amounts are in euros and translated at the same rates to sterling. The example assumes that the balance sheet does not change in currency terms from one year to the next.
5 IAS 39 para 46
6 A hedge of the exposure to variability in cash flows that is attributable to a particular risk associated with a recognised asset or liability...or highly probable forecast transaction and could affect profit or loss. IAS 39 para 86(b)
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