Australia: Tis' the Season – for cashflow lending - Is there a case for seasonally adjusted covenants?

Last Updated: 30 November 2016
Article by Roger Mattar


Tis' the festive season and retailers everywhere are breathing a collective sigh of relief that registers are ringing out loudly again across the town. It's easy to forget though, somewhere between EOFY sales and Christmas, a common issue for retailers is that their spending is up (preparing inventories for the festive season) and consumer spending may be down. If financing these higher costs cannot be achieved internally, banks are often called upon to help their customers finance their working capital needs. This type of financing is often referred to as cashflow lending.

Cashflow lending is based on a series of promises and specific financial covenants (or metrics) relating to the business and its performance (typically earnings). It aims to ensure that the cashflows of the borrower from its revenue are in step with the payment obligations under its financing arrangements.

Banks set their covenants against past financial performance, reasonable assumptions and projections and with reference to industry or bank standard measures. A key consideration from both bankers and borrowers will also be the issue of seasonality of performance or 'lumpy' cashflows. This is not just a question for retailers but a question across many industries. In this note, we consider whether there is actually a case for preparing and including seasonally adjusted covenants in a cashflow lending context.


Retailers provide a great example of a business with seasonal or cyclical working capital requirements but they are not alone – consider farmers, trades people, even lawyers and accountants. The working capital requirements across all of these sectors can vary greatly as a result of seasonal or cyclical macroeconomic factors.

Some businesses are able to finance their working capital requirements internally. More often than not though, Australian businesses seek to fund their working capital requirements via overdraft or other revolving working capital facilities from the banks. This type of finance, for working capital or other general corporate purposes, is often referred to as "cashflow lending".

Cashflow Lending

At its simplest, cashflow lending is predicated on an agreement by a lender to fund certain business activities of a borrower because of its current (and continued/forecast ) financial performance and in return for promises from the borrower to use that money in a specific way and not to do certain things to its financial resources. Central to those promises are certain financial covenants which the lender will periodically test to ensure that the borrower is performing against those covenants. Typical cashflow lending financial covenants are:

  • a fixed charges covenant - eg. committed repayment and other interest obligations under all loans of the borrower to EBITDA of the borrower;
  • an interest cover covenant - eg. committed interest obligations under all loans of the borrower to EBITDA of the borrower; and
  • a minimum net worth covenant -eg. minimum tangible net assets.

Cashflow Covenants and the Seasonality Question

The fixed charges and interest cover covenants aim to test the ability of a borrower to meet its obligations to repay its loans (together with interest and other charges on those loans) from its earnings and it is these covenants that we are concerned with when considering the effect of seasonality.

Revenue may fluctuate with seasons or in accordance with certain macroeconomic factors affecting the business or industry more broadly. Banks, when setting these financial covenants have their own internal models, from which they create a model specific to the borrower's business by inputting the borrower's past (and often projected) financial information from its financial statements, which then leads the bank to set an appropriate covenant level. An appropriate covenant level should be a covenant that will only be breached when the borrower has reached a level of financial performance which is unacceptable to the bank's risk profile for that borrower. The financial covenant is likely to then include an agreed level of headroom (to allow for deviations in actual performance to forecast performance), to be applied and tested across the entire reporting period (being typically a 12 month period), which leads to the issue: should the covenants be adjusted up and/or down over different reporting periods to reflect the seasonal or cyclical nature of a business?

Seemingly, there is a very good case for seasonally adjusted covenants. Borrowers should not breach their financial covenants simply because the financial covenants haven't included sufficient headroom to account for variations in performance which are due not to the operating performance of the business but rather due to the structural or cyclical environment within which the business operates (and which affect all businesses in that market).

Why then, do so few loans actually contain this type of adjustment? The answer, we think, may be:

  1. That banks set covenants with reference to individual historic and projected performance but also in line with bank and industry standards;
  2. That the headroom agreed in the covenants is adequate to account for seasonal adjustments to earnings and so outweighs cost/benefit for the bank to spend additional time and effort on tailoring covenants to monthly or quarterly reporting periods (where reporting information is limited to management accounts only, which may be less accurate than annual information prepared and audited by accountants);
  3. The level and sophistication of modelling and information required across a spectrum of industries may not be available.

End of Season Sell-out

Do we think there is really a case for seasonal covenants? Theoretically, yes, it makes perfect sense. Of course, pragmatically, in the SME/mid market environment, modelling covenants to that degree may be impractical and a more standardised approach with a proper consideration of requests for adequate headroom are probably adequate for most purposes. An alternative may be to have a provision which creates a 'Covenant Review' based on seasonal variations to cashflow.

Beyond that, borrowers and banks need to continue to work together to ensure that the most appropriate covenant package is structured for the nature of the business and its risk profile. Perhaps, not too far down the track, with big data, cloud computing and real time reporting, financial modelling may become more tailored and customer centric and the case for seasonally adjusted covenants may become more compelling.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

Kemp Strang has received acknowledgements for the quality of our work in the most recent editions of Chambers & Partners, Best Lawyers and IFLR1000.

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Roger Mattar
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