Understanding the Basics of Loan Covenants
Understanding the purpose of covenants and which are common or expected is the key to securing the most favorable covenants you can when you negotiate your company loan. Below are common questions we hear and a listing of the common covenants we’ve observed in the market recently.
What are loan covenants and why is the bank asking me for them?
When banks loan companies money, they want assurances that they’ll be paid back. And you, as a company, want assurances that when you commit to a purchase of inventory or equipment, for example, the funds will be there.
Banks are primarily finished with their commitments when they give you the money. You, on the other hand, have a lot to do, or in some cases, not to do. The assurances your company will make to the bank are referred to as “covenants.”
Types of Common Loan Covenants
There are as many different covenants as there are banks. The three categorical covenants listed below, along with examples, are those we are seeing as the most common in the market today.
These are used to remind the borrower that there are certain actions they should be taking to ensure the long-term health of their business. Many of these are intuitive and natural but are meant to be triggers for warnings to the bank if not performed. These include:
- Operational Covenants like keeping compliant with GAAP, paying taxes timely & complying with stated laws.
- Reporting Covenants like quarterly financial statements and annual audits…each of which should be performed in a proscribed time frame.
Banks use these to create boundaries for owners and the company. The goal is to keep the company from radically reducing the underlying company value or its ability to pay the bank back. These usually include most of the following:
- Investment – limiting non-standard purchases, E.g. mergers/acquisitions, without bank approval
- Asset Sale – restricting the sale of valuable assets outside of the “ordinary course of business”
- Cash Payout – preventing distributions to owners or other shareholders
- Financing – limiting additional indebtedness of any kind without prior bank approval
These covenants are based on the specific balance sheet or income statement items or ratios of those items. The ratios are generally set according to how the business said it’d perform (via projections provided to the bank by the company during negotiations). Then they are used to measure how the business lives up to its performance commitments. They may also be used to restrict the amount of available funds to borrow, as in the case of a line of credit. Common covenants used here are:
- Borrowing Base. Usually applied to lines of credit, this is usually defined as a portion (often between 50-75%) of “eligible Accounts Receivable plus a portion (often between 30-50%) of “eligible inventory”. Here, the goal of the bank is to be assured they’re loaning less than what they could liquidate AR and inventory for, if necessary.
- Interest Coverage Ratio. This ratio is always higher than 1, is typically 1.5-2.5, and may move up over the life of the loan. It is defined as Annual EBITDA / Annual Interest Expense. Banks prefer this ratio to test whether current year earnings are in excess of current year interest expense.
- Debt Service Coverage Ratio. Typically the same as Interest Coverage Ratio, but the denominator includes other debt items such as the Current Portion of Long Term Debt.
Why is it important for me to monitor them?
If one of your covenants is violated, or “tripped”, the banks can declare the company in default which usually results in a formal letter of default from the bank.
However, if you’re doing a proper job monitoring your covenant compliance, see a potential “trip” coming, AND make the bank aware in advance, they are far more likely to react cooperatively.
But if the day does come that you receive a letter of default, don’t let this cause a panic attack because it is usually coupled with a solution offered by your bank. Your bank is generally willing to work with your company because they want to give themselves the greatest chance they’ll collect their debt …and that usually comes from cooperation rather than immediately calling the loan. Frequently, these solutions will already be spelled out by the “remedies” in the agreement. Other actions may include, in order of most to least frequently enacted:
- Increasing the interest rate to the “default rate”
- Ceasing to advance new funds
- Prohibiting distributions to subordinated debt (debt lower in priority than theirs)
- Calling the loan (asking for full repayment)
- Repossessing collateral
- Legal action against the borrower
Banks can be wonderful partners as you grow your business. But as partners, they should be treated equitably. If you have a loan, the more you monitor and understand your covenants, the better your relationship and cooperation will be with the bank. Be sure to ask the right questions of your CFO or controller to see that they’re monitoring these properly.