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p. 43 of 203 BACK | NEXT Foreword 1. Introduction to the Guidelines 2. User Instructions 3. Preparing and Appraising Investment Project 3.1. Investment Projects Overview 3.2. Possible Investment Projects 3.3. Appraisal Checklists 3.4. Forecasting 3.5. Preparing Financial Benefit-Cost Analyses 3.6. Loan Covenants 3.6.1. Introduction to Loan Covenants 3.6.2. Operating Covenants 3.6.3. Capital Structure Covenants 3.6.4. Liquidity Covenants 3.7. ADB Reports 4. Financial Management of Executing Agencies 5. Reporting and Auditing 6. Financial Institutions 7. Knowledge Management

Financial Management and Analysis of Projects : 3. Preparing and Appraising Investment Project : 3.6. Loan Covenants

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3.6.4. Liquidity Covenants

3.6.4.1. Introduction to Liquidity Covenants

3.6.4.1.1. Liquidity covenants are intended to assure that an enterprise maintains sufficient working capital (i.e., an excess of current assets over current liabilities) to meet its current obligations in a timely manner and conduct its operatios effectively, without financial constraints.

3.6.4.1.2. Their limitations are that the data used for the ratio is a "snapshot" figure, usually as at the end of a fiscal period-and, as such, are capable of manipulation. They are generally used only when working capital requirements are significant, as in the case of most industrial and agro-industrial projects, where the enterprise's management may use limited resources to fund capital expenditures to the detriment of operating expenses. By contrast, these covenants are not normally needed in projects where working capital needs may be relatively small, such as utilities and railways.

3.6.4.1.3.The cash needs of such projects are adequately covered through operating covenants, supplemented, as necessary, by other covenants dealing with working capital issues, such as timely collection of accounts receivable.

3.6.4.1.4. The current ratio and quick ratio covenants require the borrower to maintain a specified minimum liquidity ratio and to undertake corrective actions if the actual ratio falls below the prescribed level. The quick ratio covenant excludes the cost of inventories at the date of the balance sheet.

3.6.4.2. Current Ratio Covenant

3.6.4.2.1. The advantages of the current ratio covenant are that: (i) it is simple and easily understood by borrowers, (ii) it is based on an accurate and objective test, (iii) it can be based on readily defined accounting principles and calculated from standard financial statements, and (iv) in most cases it provides a fair representation of short-term solvency of the borrower. Section 4.4.8.2 describes the application of this covenant and a model is provided in Knowledge Management (section 7.14.1).

3.6.4.2.2. However, this covenant will only be an adequate test of liquidity if the covenant design provides for: (i) periods of falling sales and consequent declining internal cash generation, when the borrower may find it difficult to convert inventories to cash at reasonable prices; (ii) a suitable analysis of inventories, because some items may be nonsaleable (for example, they may be spare parts or obsolete products not written off) and because a minimum level of inventories must be retained to continue operations; (iii) a suitable analysis of accounts receivable; and (iv) seasonal variations in working capital requirements and interim peaks for debt maturities during the year. These problems, although serious in some projects, can be overcome either by making appropriate allowances when determining the acceptable ratio, or by using the quick ratio test. The borrower should be asked to calculate and confirm compliance with the current ratio at intervals throughout the fiscal year (e.g., in quarterly or semiannual reports; or whenever requested by ADB).

3.6.4.2.3. This covenant requires consistent and close monitoring to ensure that unacceptable management and accounting practices are not being followed to give the appearance of compliance. For example, accounts receivable may be overstated because of inadequate provisions for bad debts.

3.6.4.2.4. In some instances, it may be necessary to introduce supporting covenants that specifically address such key issues as the size of short-term debt, or levels of inventories and receivables.

3.6.4.3. Quick Ratio Covenant

3.6.4.3.1. The quick ratio covenant is similar to the current ratio covenant, except that inventories are excluded, to focus on the most liquid items in the financial statements. Section 4.4.8.2 describes the application of this covenant and a model is provided in Knowledge Management (section 7.14.2).

3.6.4.3.2. It gives a much clearer view of the "cash" position of the enterprise. After taking that benefit into account, this covenant still has the shortcomings associated with the current ratio.

3.6.4.3.3. While any selected covenant must be framed to reflect the objectives of the borrower and the project, it is probably desirable when a decision has to be made between the current and quick ratios, to select the latter and to require at least a three-monthly submission of information; and introduce a performance covenant to address control of inventories. In this way the cash position can be examined closely and regularly.

3.6.4.4. Dividend Limitation Covenant

3.6.4.4.1. The dividend limitation covenant with a dividend limitation test prohibits the borrower from declaring a dividend the payment of which would cause the current ratio (or quick ratio) to fall below a specified minimum. Section 4.4.8.3 describes the application of this covenant and a model is provided in Knowledge Management (see 7.14.3).

3.6.4.4.2. The minimum level of current ratio specified in this covenant may be higher than the minimum required under the current ratio covenant discussed in section 3.6.4.2 because decisions on whether to pay dividends are often discretionary, and a stricter standard of prudent financial management can thus be applied to this context. Therefore, the borrower is asked not to make voluntary payouts of cash to its stockholders until it has taken further measures to establish and maintain the liquidity essential for operations.

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