In the financing of overseas transactions, the granting of loans by lenders to borrowers is accompanied by a series of requirements that borrowers must comply with after determining the lending relationship. Overseas lenders are very strict with the requirements and management of borrowers after loans. The author has repeatedly encountered situations where foreign financing banks require seats on the board of directors of the target project company. A series of related commitments made by a borrower to a lender in connection with obtaining a loan. An important part of the lender's obligations to the borrower after the loan is reflected in financial covenants. In addition, there are non-financial commitments, which will be detailed in a separate article.

1、 Meaning of financial commitments

According to these terms, the borrower promises to the lender that after accepting the loan, it will accept corresponding constraints on its financial status and maintain the financial status required by the lender. Related to this are relevant financial ratios, where borrowers promise to maintain their own or related guarantors' status above or below these indicators.
For lenders, financial commitment is like a safety net, enabling them to maintain a certain degree of control over the borrower after the loan is issued, ensuring that the borrower's solvency will not be damaged by the borrower's business decisions, thereby providing lenders with a grip on ensuring the borrower's financial stability. The lender may waive the requirements for financial commitments in whole or in part, permanently or temporarily, but this is entirely at the lender's discretion. It can be seen that financial commitment terms provide the protection and security sought by lenders in overseas financing transactions, and are a safety net that lenders rely on in transactions.

For the lender, in order to achieve its financial commitment, the lender will make corresponding adjustments to its business activities and give up relevant business decision-making rights. Therefore, an important task for lenders and borrowers in the term sheet stage and the negotiation of loan agreements is to clarify, explain, negotiate, and ultimately determine the financial indicators and related obligations determined by the financial commitment terms. The main and common financial commitments are discussed below, one by one.

2、 Financial commitments

（1） Classification

Financial commitment clauses can be divided into positive financial commitment clauses and negative financial commitment clauses. Positive financial commitment clauses refer to clauses related to financial indicators that borrowers promise to achieve, such as maintaining certain financial indicators within a certain range; The negative financial commitment clause refers to a commitment that a borrower must avoid relevant situations, such as a commitment not to sell assets or not to borrow new debt.

Financial commitment clauses can be divided into continuous financial commitment and trigger financial commitment. Continuing financial commitments refer to financial commitments that creditors require an enterprise to continuously meet and maintain during a specific period of time (usually the loan duration). For example, lenders require borrowers to maintain certain financial indicators that are not lower or higher than a specific value; Triggering financial commitments refer to financial commitments that are triggered only under specific circumstances, or that serve as a precondition for borrowers to conduct specific actions, such as the distribution of profits by borrowers, or the preparation of new mergers and acquisitions.

Financial commitments can be divided into historical data financial commitments and projected data financial commitments. Historical data financial commitments refer to commitments that are measured based on the financial data that the borrower has achieved, while projected data financial commitments are calculated and approved based on the prediction model developed by the borrower.

（2） Common financial commitment indicators

1. Leverage ratio (Debt/EBITDA)

This indicator measures the leverage ratio of the debt undertaken by the borrower and the length of time the borrower needs to repay the debt while maintaining current income. Financial indicators related to this also include the Debt/(EBITDA – Capex) ratio, and so on. As mentioned earlier, this indicator can be further divided into two dimensions: maintained and projected. Both parties shall negotiate and determine this based on debt amortization and operation forecast.

From its calculation formula, it can be seen that the lower the Debt/EBITDA ratio, the lower the debt ratio of the borrower, and the borrower has sufficient cash flow to repay the principal and interest. On the contrary, it indicates that the borrower has a high debt burden and a serious lack of solvency. Therefore, in this clause, the lender usually requires the borrower to maintain its Debt/EBITDA ratio not exceeding a certain proportion. Generally, when the ratio of net debt to EBITDA is greater than 4 or 5, it indicates that there is a problem with the borrower's solvency, and the rating agency will downgrade the borrower accordingly. Due to the different capital requirements of different industries, Debt/EBITDA needs to be negotiated and determined based on each project. In the author's work experience, the ratio of net debt to EBITDA determined with the lender usually does not exceed 3.5:1 or 4:1.

Tangible Net Worth

Tangible net worth is calculated as the borrower's total value minus intangible assets. This indicator is used to measure the value of borrowers, but excludes intangible assets that are difficult to realize, such as intellectual property rights and goodwill. The lender measures the borrower's asset's ability to repay its debts.

The lender's tangible net worth and leverage ratio are the two most important financial indicators, the former indicating the borrower's own liquidity, and the latter indicating the borrower's solvency. Therefore, the former is commonly used in investment grade loans, while the latter is commonly used in project loans, mergers and acquisitions loans, and other projects that rely on the underlying cash flow.

Typically, lenders require borrowers to maintain a certain amount and a minimum percentage of tangible net worth during the loan period.

Interest Coverage Ratio (ICR)

The interest coverage ratio measures the borrower's ability to repay its interest payable, and there are two calculation formulas: EBITDA ÷ Interest, or EBIT ÷ Interest. During negotiations, it is necessary to clearly determine the calculation method of ICR to avoid ambiguity.

From the formula, it can be seen that the higher the interest coverage rate, the stronger the ability of the company to repay interest from operating income, and conversely, the poor financial situation of the borrower, even tending to bankruptcy. On the other hand, the higher the interest coverage rate, the less investment motivation the company has and the failure to maximize its business potential. Generally, the negotiation range for the interest coverage ratio is below 2, but there is also a possibility that the lender may require more than 3 if the borrower does not have sufficient stable cash flow.
Debt Service Coverage Ratio (DSCR)

The debt service coverage ratio measures the borrower's ability to use its operating income to repay debts, including the ability to repay principal and interest in both long-term and short-term time dimensions. The calculation formula is the funds available for repayment of principal and interest/the amount of principal and interest payable in the current period.
When the debt service coverage ratio is greater than 1, it indicates that the borrower has sufficient operating income to repay its debts. If it is less than 1, it indicates that the borrower's operating income cannot cover its debts. For example, a borrower's debt service coverage ratio of 0.8 indicates that the income generated from its operations can only repay 80% of its debt. Generally, lenders require borrowers to maintain a debt service coverage ratio above 1.5X.

In addition to the four most common financial indicators mentioned above, the financial indicators used in projects also include total assets, debt/equity ratio, debt/assets ratio, and fixed charge coverage. Due to space constraints, I will not repeat it. In specific projects, based on the characteristics of different industries and the specific work of the project's lenders and borrowers, we will determine the acceptable threshold values of financial indicators for both parties.

（3） Remedies for Breach of Financial Commitments

If the borrower needs to meet continuous financial commitments and fails to meet current commitments during a certain reporting period, the lender can request the borrower to provide relief through the following mechanisms:

1. Capital cure

When a borrower fails to meet its financial indicators, a relatively direct remedy is for shareholders of the borrower (or guarantor) to supplement the borrower's cash gap, improve its EBITDA and cash flow, and thereby improve its financial indicators by injecting capital. However, this approach only provides a Band-Aid for long-term blood loss of borrowers, and it will also cause further concentration of equity ratios and further increase in the debt to equity ratio (leading to default of debt to equity ratio financial commitments). Therefore, the lender is very cautious about the application of capital relief and may impose restrictions from the following aspects:

● Limit the upper limit of the amount of capital relief injected

● Limit the number of times capital relief can be used during the loan term

● Restrict the remedy time for capital relief. Generally, the remedy time is consistent with the time when the borrower submits financial statements under the loan agreement, which is 15-45 days

● Limit the scope of remedies available for capital relief: Lenders typically limit the financial commitment breaches that can be remedied by capital relief, such as agreeing to only remedy cash flow related breaches

● Scenarios that restrict its use, such as if the borrower's business has lost hematopoietic capacity and cannot be maintained by injecting capital

● Make clear agreements on the use of injected funds, especially to prevent borrowers from merely improving their financial performance on paper (Round Tripping)

2. Cash sweep

In project financing, the lender may specify in the loan agreement that, in the event that the borrower fails to meet certain financial commitments, it will directly transfer the cash available for debt service (CFADS) from the borrower's account for early repayment. The calculation of repayable cash is linked to the debt service coverage ratio. Through cash mopping up, borrowers have reduced their debt and interest burdens, improving the performance of their financial indicators, thereby ensuring that borrowers meet their financial commitments.

（4） Liability for Breach of Financial Commitments

In the event that the borrower breaches its financial commitments and fails to receive relief, the borrower may face the following liabilities:

● Lenders request and borrowers restructure debt

● Require the borrower to pay liquidated damages

● Increase the interest rate on defaulted loans

● Require the borrower to provide supplementary collateral

● Accelerated maturity of a single loan

● Termination of Loan Agreement

3、 Conclusion

As the core system of cross-border financing transactions, financial commitment is the key to both the lender and the borrower, the most important guarantee for the lender's loan safety, the most important obligation for the borrower after the loan, and the most important part of negotiations between the two parties. This article attempts to provide an overview of financial commitment terms. We hope to discuss with our customers the application of financial commitment terms in more detail in specific projects.