Credit Agreements. You might need a strong pot of coffee to do this, but the key to you mastering the credit agreement you live by starts with understanding the definitions section of the agreement. In this post, I’m going to cover some of the most common areas you’ll need to understand when it comes to definitions of terms.

The definitions section is typically found at the front section of most credit agreements. It is typically sorted in alphabetical order. Get your highlighter or pen out to start marking up the things that matter most. Many definitions will refer to other defined terms, so don’t be surprised if you have to trace a certain term throughout the definitions section to identify its full meaning and components.

Example: Working Capital Definition:

Net Working Capital, or Working Capital, however it is defined in credit agreements is a crucial part of your post-close life as CFO. Everyone else involved in the deal will also be quite interested as there are usually three parts to finalize the purchase price of an LBO. These are 1.) the initial purchase price 2.) the post-close adjustments and 3.) contingent consideration. The post-close adjustments are generally final working capital and final indebtedness. For now, we’ll focus on the working capital part.

Here is how your agreement will most likely be written when it comes to working capital: 1.) Net Working Capital will equal Current Assets minus Current Liabilities as of the closing date of the transaction. 2.) Current Assets will typically be defined and may either direct you to a schedule with an illustrative calculation or set of GL accounts, or be prescriptive with respect to the accounting standards or past practices imposed.

Examples of Things to Look out for in Credit Agreements:

Right off the bat you need to know the closing date, and the exact closing time. Was it midnight of a certain date, and was that date a calendar or accounting month-end date/time, or do you need to look at things on a mid-month basis?

Is applying US GAAP the standard to adhere to, or does the definition section allude to past accounting practices as the guide to how the accounting for working capital related items should be done? Read your agreements carefully because the sequence of words matters…for example, if “in accordance with past practices, to the extent those past practices are in agreement with US GAAP” is the language to live by, then you can only use the accounting practices used during the seller’s ownership to develop your working capital calculation, as long as those practices fall within the definition of US GAAP.

Covenants: There are also sections for approved indebtedness, affirmative covenants, negative covenants and financial covenants that you must understand. More on those posts in this credit agreement related series.

Summary:

Definitions are the foundation of all credit agreements. You should be well versed in them because each of them will have implications on the way you abide by your agreement and the responsibilities you have to uphold the agreement. This portion of the document is not always the most exciting to read but it is the foundation of the financial instrument that likely comprises at least half of your capital structure.