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Financial Management and Analysis of Projects : 3. Preparing and Appraising Investment Project : 3.6. Loan Covenants
3.6.2. Operating Covenants3.6.2.1. Introduction to Operating Covenants3.6.2.1.1. To assist the governments of its member countries in the efficient management of scarce resources, including the mobilization of revenues and savings, ADB recommends to borrowers that their public and private sector revenue-earning enterprises be required to meet a "reasonable portion" of their investment requirements from internally generated funds. Definitions of "reasonable portion" will vary between countries and sectors, frequently based on a government's policies for public sector EAs. It will also be dependent on the latest performance of the EA, particularly if its current financial performance is inadequate to support its operations, when the "reasonable portion" may need to be substantially increased above current performance. 3.6.2.1.2.The principal legal instrument through which ADB seeks to assure such a financial performance of a revenue-earning enterprise is a form of "operating covenant". The two principal forms of operating covenants are the Rate of Return and the Self-Financing Ratios. Each specifies the minimum annual financial performance to be achieved by a public sector enterprise in terms of either the rate of return on invested capital, or the contribution to investment requirements to be generated from the enterprise's operations. 3.6.2.1.3.Competition has been limited in the market(s) in which such enterprises operate (although there is evidence of an opening of many of these markets, at times as a result of related ADB projects or programs in the same sector). Levels of output prices may be adjusted by the enterprise's management board (for example, Public Boards of Management for Electric Power) or the Government may control or regulate tariffs and charges through the concerned sector ministry, the Ministry of Finance, or the Cabinet. In such cases, operating covenants serve to require a management board or a government to authorize tariffs and prices that provide for a satisfactory financial performance by the EA or enterprise. Where an independent regulator regulates the sector, the enterprise and/or the government may not have the same degree of discretion to adjust output prices or tariffs and charges. In such cases, operating covenants serve the same purpose, but the enterprise may need to take alternative measures (such as tighter controls on operating expenditures) to meet such covenant, in addition to making applications to the regulatory authority to increase tariffs and charges. 3.6.2.1.4.When the performance of the EA has been very poor, forms of operating covenants used include the operating ratio covenant, or the breakeven covenant. Depending on the ratio specified, the operating ratio covenant may serve a variety of financial objectives, but it is usually limited in its application; for example, ensuring that earnings would at a minimum cover operating expenses including depreciation and, to the extent possible, debt service requirements in excess of depreciation. The breakeven covenant has similarly limited objectives intended to ensure the continued operating capability, solvency, and financial viability of the public sector enterprise. It is used where internally generated funds are not expected to contribute significantly to investment. 3.6.2.1.5.Operating covenants should contain provisions for periodic reviews by the enterprise of the actions required to achieve compliance and for furnishing the results of such reviews to ADB. Such reviews should be made at least annually before the beginning of a fiscal year to permit the enterprise to take timely action. In some cases where financial information is late in delivery, such reviews would need to be made on the basis of firm estimates and the specific forecasts noted for revision when final data is available. In highly inflationary economies, more frequent reviews (e.g., quarterly) may be needed. 3.6.2.2. Rate of Return Covenant3.6.2.2.1. Under the rate of return covenant, an enterprise affirms that it will take all actions necessary, including changes in its tariffs, rates, and charges, for its revenues each year to cover operating expenses and taxes, if any, and to earn an agreed return on its invested capital. Section 4.4.6.2 provides guidance on the application of this covenant and a model covenant is provided in Knowledge Management (see section 7.12.1). 3.6.2.2.2. This covenant is most frequently applied to public sector enterprises constructing and operating projects in the sectors, which embrace agribusiness, electric power, ports, telecommunications, gas or fuel pipelines, water supply, and sanitation. The rate of return covenant is generally less suitable for sanitation and sewerage projects, because they have considerable difficulty in generating surpluses for investment or reserves and therefore these projects are normally combined with those of water supply as part of a water supply utility enterprise operation. 3.6.2.2.3. Competitive factors bear significantly on the financial performance of industry (including oil and gas). Therefore, a specific rate of return covenant is used infrequently in this sector. Instead, a less precisely defined form of the rate of return covenant, the general price covenant (see next paragraph), is usually used. 3.6.2.2.4. For railways, the rate of return on invested capital may be used but a commonly used covenant is the operating ratio. 3.6.2.3. Self-Financing Ratio Covenant3.6.2.3.1. A self-financing ratio covenant, a model of which is provided in Knowledge Management (see section 7.12.2), directly addresses the need for sufficient internal cash generation to finance consistently an agreed proportion of investment requirements. Section 4.4.6.3 discusses the application of this covenant. 3.6.2.3.2. It is often used when a more direct approach to addressing cash generation requirements is considered desirable. Borrowers often favor the covenant because it is more readily understood, particularly by politicians and administrators; it is less costly to put in place and maintain; it avoids setting aside funds which may occur with the rate of return covenant, but it may be manipulated. This latter action may arise if a borrower deliberately decides to match its annual investment plans to whatever level of net revenues becomes available, to comply with the covenant. As an example, a borrower required to contribute 20% per annum to its investment program from internally generated revenues, can comply by financing $100 million from $20 million internally generated revenues, but is similarly in compliance by financing only $25 million of investments with $5 million of revenues. 3.6.2.3.3. Despite the selection of an extended review period (3 years) as the base for determining investments, the objective of the covenant can be avoided by a borrower failing to implement acceptable levels of annual investments, with the result that the revenues required to be generated internally can be allowed to fall correspondingly. The significant and likely impact of this default is a failure by the borrower to expeditiously execute the project, directly due to the reduction of the level of investment agreed between the borrower and ADB in the project implementation and financing plans. 3.6.2.3.4. A further problem associated with determining the self-financing ratio for a covenant is the often-uneven nature of investment programs (i.e., the pattern of investments can vary widely from year to year). A 3-year investment pattern for a public sector enterprise could be $10 million, $77 million, and $12 million. Such a program with a 3-year moving average would show for that period an average of $33 million. If the borrower was required to raise 30% from internally generated revenues annually, the result would be a surplus in year one of $23 million, a shortfall of $21 million in year 2, with parity arriving only in year 3. Under these circumstances, it may be difficult for a borrower to justify politically the raising of charges to yield a very large surplus in year one. While it may forecast to complete $77 million in year two, this may be treated as a dubious estimate by a government that is hardpressed for resources. 3.6.2.3.5. This example makes the case for smoothing several years' performances, but does not provide a ready or politically realistic justification for tariff and charges increases for an as yet unaccomplished investment program. 3.6.2.4. General Price Level Covenant3.6.2.4.1.The model covenant provided in Knowledge Management (section 7.12.3) illustrates the possible formulation of this type of covenant, the drafting of which should be carefully adapted to the circumstances of the particular project. The main purpose of the covenant is to set forth the agreed criteria applicable in determining prices, and to provide for consultation with ADB. Because it is not feasible to be precise, the criteria should be expressed in general terms. 3.6.2.5. Operating Ratio Covenant3.6.2.5.1. An operating ratio covenant requires a public sector enterprise to set its tariffs and rates at levels that meet a specified operating ratio test (section 3.6.1.9). The covenant may also state a minimum reduction in the operating ratio to be achieved by a specified date, as part of an agreed effort to improve operating efficiency and, in some cases, eliminate uneconomic services. Section 4.4.6.4 discusses the application of this covenant and a model is provided in Knowledge Management (see section 7.12.4). 3.6.2.5.2. This covenant is normally used only where it is not feasible to use a rate of return or cash generation approach-for example, for an entity which has been incurring substantial operating losses and whose objective is to eliminate such losses. It may also be used for a revenue-earning entity that is likely to be restricted by government from generating appropriate amounts of capital for future expansion purposes. It is usually necessary to supplement an operating ratio covenant with agreements by the concerned government to provide necessary funds to offset operating deficits until they are eliminated, to cover any deficiencies in meeting debt service obligations, and to assist in financing capital needs. 3.6.2.5.3. A variant, the working ratio covenant is sometimes used to emphasize the degree of coverage of cash operating expenses. It excludes depreciation and similar noncash items from expenses. 3.6.2.6. Breakeven Covenant3.6.2.6.1. A breakeven covenant is designed to achieve financial viability in its most limited sense. There are two breakeven variations: revenue (accrual) breakeven; and cash breakeven. This section, and the model covenant, refers to the former variation. The covenant requires the entity to take all measures necessary, including adjustments in its rates, for revenues to cover operating expenses, adequate maintenance, taxes if any, and the greater of depreciation or debt service requirements. The objective of this analytical tool is to measure a revenue-earning enterprise's efforts to breakeven, without losses and without providing any surpluses for investment, dividends, etc. 3.6.2.6.2. This approach is occasionally used for transportation and similar projects that follow the principle of funding their capital requirements predominantly through borrowings or grants, and also receive operating subsidies. It is infrequently used for the public sector, and is unlikely to be used for private sector projects. It compares the total revenues of an enterprise with the operating expenses plus the amount by which debt service requirements exceed the provision for depreciation. 3.6.2.6.3. The major risk in the use of this tool is that the borrower/EA may become complacent if a breakeven is achieved, and will fail to pursue more aggressive revenue-earning policy to provide for the gradual removal of all subsidies. This tool should not be introduced without a detailed justification at fact-finding, and in the RRP. A detailed breakeven analysis, displaying the effects of changes in volume on the breakeven point(s), and on profitability and cash flows should be developed. 3.6.2.6.4. The RRP should include a forecast of when a self-financing ratio should be introduced, and if debt service is not being met completely, or at all, the steps which the government and the enterprise propose to take to recover debt service from consumers through the charging system(s) of the enterprise. 3.6.2.6.5. Section 4.4.6.5 discusses the application of this covenant and a model is provided in Knowledge Management (see section 7.12.5).
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