A borrower with $200 million in long-term notes trips a 4.0x leverage covenant by 0.1x at year-end. Without a waiver, $200 million jumps from noncurrent to current on the balance sheet, working capital flips negative, and the company is technically insolvent overnight. One ratio, one quarter, one decimal point.
Lenders write covenants because once cash leaves the bank, the only protection left is contractual. Covenants give the lender early-warning rights and the ability to renegotiate or accelerate before things get worse. The exam tests three things: identify the covenant type, compute the ratio, and apply the right balance sheet treatment when a covenant breaks.
Affirmative covenants are positive obligations the borrower must perform. They are not calculation-driven; you either did the thing or you did not.
Common examples: maintain property insurance, file audited financial statements within a specified window (often 90 or 120 days after year-end), pay taxes when due, maintain corporate existence, allow lender inspections, deliver compliance certificates each quarter.
Common mistakes
- Reclassifying long-term debt as current after a year-end waiver. A waiver signed three months after year-end but before financial statements are issued generally preserves long-term classification. Candidates who reclassify because the violation existed AT year-end miss the rule. ASC 470-10 evaluates the lender's rights as of the issuance date, not the balance sheet date.
- Using net income instead of EBITDA in the leverage covenant. Debt/Net income would produce a much higher ratio than Debt/EBITDA. A company with $300M debt, $24M net income, and $88M EBITDA would compute 12.5x using net income instead of the correct 3.41x, flagging a false violation.
- Forgetting to remove goodwill from tangible net worth. Tangible net worth excludes goodwill and other intangibles. A $260M equity company with $80M goodwill has only $180M of TNW. Using $260M would falsely report compliance with a $200M floor.
Bottom line
- Covenants come in three types: affirmative (must do), negative (must not do), financial (must hit a ratio).
- Affirmative and negative breaches occur at the moment of the prohibited or omitted act; financial covenants are tested at measurement dates.
- Covenant compliance means computing the agreement's defined ratio (leverage, coverage, liquidity, or net worth) and comparing it to the threshold.
- Total leverage equals Debt/EBITDA and must stay at or below the ceiling, where EBITDA = Net income + Interest + Taxes + Depreciation + Amortization.
Exam shortcut
When a question gives you a covenant formula and balance sheet data, build the inputs in this order: EBITDA first (it powers leverage AND fixed-charge coverage), then EBIT (interest coverage), then balance sheet ratios (current, debt-to-equity, TNW). The trap answer usually uses Net Income where EBITDA was required, or includes goodwill in tangible net worth. For the reclassification question, three rules in sequence: covenant violated as of balance sheet date?
The full lesson (about 2,985 words, 20 min read) adds 2 worked examples, all 6 common mistakes, a self-check, free in the app.
Learning objectives
- II.H2
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