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Financial Management and Analysis of Projects : 3. Preparing and Appraising Investment Project
3.6. Loan Covenants3.6.1. Introduction to Loan Covenants3.6.1.1. As discussed in section 4.4, various performance measurement devices have been developed over time to enable owners, lenders and managers to assess enterprise and project performance. To assist EAs to achieve their financial objectives, as well as governmental economic objectives that are being supported by ADB loans, ADB seeks assurance that the operational objectives of an EA agreed with the borrower, would be met at least through the life of the project. The Office of the General Counsel (OGC) translates these objectives into covenants. These covenants are designed to: (i) enhance the financial performance of the entity; and (ii) ensure that the investment, including ADB loan proceeds, is used effectively. 3.6.1.2. ADB asks its borrowers to perform or comply with certain covenants that are considered essential to achieving the objectives and financial viability of the project as described in the loan agreement in a manner that is consistent with ADB's policies and to ensure the financial viability of the entity. Covenants in loan agreements seek the achievement of enterprise objectives. They are varied in nature, often addressing technical, social, and economic performance, in addition to financial performance. Financial performance covenants can be broadly classified into two categories, namely financial and management systems, and financial performance. Financial and management system covenants usually address such specific problems as selling and marketing practices, inventory control, installation and operation of accounting and costing systems, control of labor and material costs, strategic and financial planning, budgeting systems, etc. Financial performance covenants are designed to: (i) support socioeconomic development; (ii) promote financial viability, satisfactory financial performance, and prudent financial management of an enterprise; (iii) development of local capability to manage without external assistance not only under normal business conditions, but also in adverse operating or trading circumstances; (iv) assist the enterprise to achieve a creditworthy status to facilitate acceptance in capital markets; (v) protect the borrower's and ADB's financial interests; and (vi) provide a basis for monitoring by regulatory agencies of government, and ADB, of the financial performance of the enterprise. These are largely complementary objectives, but trade-offs may be required between financial and socioeconomic considerations. 3.6.1.3. Frequently, there is a need for a public sector enterprise to provide services to lower-income groups at or below the financial or economic cost. This raises issues of whether an enterprise and a sector should be responsible for cross-subsidization, whether the government should finance the costs through subsidies either to the enterprise or directly to the beneficiaries, and whether the enterprise should be allowed to set lower financial targets which recognize the inability of certain users to meet actual and/or marginal costs. In the latter case, the setting of lower financial targets should not normally be acceptable. If the financial targets are correctly designed their lowering can only risk the future reliability of the enterprise to provide a quality of service or product to all consumers. Such issues must be resolved as part of project preparation and discussed in the RRP. Because financial performance indicators are used as the basis for measuring the foregoing, it is essential that the most appropriate indicator(s) be selected for each covenant for each project and enterprise. 3.6.1.4. The financial analyst and the project designers should ensure that, to the extent possible, financial systems covenants and financial performance covenants are complementary. They should be viewed as a comprehensive package designed to achieve an integrated financial performance by the enterprise's management. 3.6.1.5. A list of the proposed financial performance covenants, which have been subjected to sensitivity analyses (see section 3.5.4), should be provided together with the RRP. 3.6.1.6. Finally, to be consistent with a government's socioeconomic objectives, before the final formulation of financial performance requirements and of the related covenants, appropriate cost recovery principles and efficiency improvements, and the fiscal impact and distributional effects must have been weighed by the appraisal mission, particularly by the financial analyst. 3.6.1.7. Some indicators and covenants, such as a dividend limitation covenant, which are discussed in the following sections, are less extensively used by ADB than by other lenders. However, to ensure that a financial analyst is well informed on their construction and use, they also are described in the loan covenant section. 3.6.1.8. Whenever a date or month is needed in each of the succeeding model covenants, it is to be understood that an appropriate date or month should be inserted. This is to ensure that the review is conducted no later than the end of the first quarter of a fiscal year and such review should be in respect of the fiscal year in which the review is conducted and the succeeding year. 3.6.1.9. In cases wherein the borrowers may not have absolute control or discretion over the level of tariffs or where an independent regulator regulates the sector, operating covenants serve the same purpose. However, in addition to making applications to the regulatory authority to increase tariffs and charges, the enterprise may need to take alternative measures (such as tighter controls on operating expenditures) to meet such covenants.
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