Meaning
A systematic review of a borrower’s outstanding debt relative to its operating earnings occurs at pre-determined intervals to ensure compliance with a loan agreement. This process, referred to as leverage testing, operates as a primary risk management tool for lenders to monitor creditworthiness. It measures the ratio of total debt to EBITDA against a declining maximum threshold over the life of the loan.
Measurement Frequency
The evaluation typically takes place at the end of each fiscal quarter. The borrower must submit a compliance certificate signed by the chief financial officer.
Ratio Calculation
The debt figure used in the calculation is often net of cash held on the balance sheet up to a certain limit. EBITDA is calculated on a trailing twelve-month basis, adjusted for permitted add-backs and non-recurring items. The resulting ratio must remain below the contractual limit to avoid a covenant violation.
Compliance Outcome
Failing the test gives lenders the right to declare a default. In practice, it usually leads to a renegotiation of loan terms or an increase in the interest rate. Companies that pass the test maintain their operational freedom and may benefit from lower interest margins if a pricing grid is in place.
