Banks often include loan covenants in their documents when they lend to businesses. These covenants can be thought of as restrictions that the bank sets to help protect it from loan losses. Generally, covenants fall into three categories: affirmative or active covenants, negative covenants, and financial covenants.
As a business owner or manager, you should understand your loan covenants, and you should periodically verify that your company is adhering to these requirements. Significant covenant failures or repeated failures can lead to a loan default. Also, bankers do not like covenant surprises, so if you project a covenant violation, you should discuss this with your banker in advance.
Affirmative or Active Covenants. These covenants usually require a business to take action such as providing accountant-reviewed or audited annual financial statements. The bank might also require copies of company-prepared, monthly or quarterly, financial statements or copies of the business tax returns.
If a bank provides a line of credit to finance seasonal growth, the bank may ask for copies of the monthly inventory and accounts receivable aging reports. Specific due dates for these reports are included in the loan documents, and businesses should provide this information on or before the due date.
Negative Covenants. These covenants usually define what a company cannot do. Some restrictive covenants are obvious: a company cannot go bankrupt or the loan immediately becomes due, collateral already held by the bank cannot be pledged as collateral to someone else, and/or the company cannot be sold or ownership significantly change or the bank must be paid.
Other negative covenants may be added based on a company’s specific financial condition: dividend payments or the repayment of loans to owners may be prohibited, or rental increases may not be allowed if rents are paid to company owners.
Financial Covenants. These covenants are often financial ratios that are calculated using figures from a company’s financial statements. The mathematical formula is defined in the loan documents, and these calculations must be performed at specific times (annually, quarterly or monthly).
Banks may use different ratios for different industries, and banks may adjust these limits based on a company’s financial strength. For example, a company with little debt and significant cash reserves might have a lower financial covenant requirement than a firm with high debt and little cash. Different banks even calculate similar ratios using different formulas, so it is important to understand the calculation method that is used.
Some of today’s more common ratios fall into two categories:
Debt coverage. These ratios measure financial performance and cash generated by the business. Fixed Charges to EBITDA, Debt Service Coverage, or Fixed Charge Coverage ratios are used to compare a company’s cash flow to its debt and other fixed charge payments over a specific period. Banks use these ratios to confirm that a company is generating sufficient cash to repay the bank’s loan and, in some cases, other fixed charges.
Leverage. These ratios compare a company’s level of debt to its net asset value, equity, or cash flow, and this financial covenant may be called Debt to Tangible Net Worth, Debt to Equity, or Funded Debt to EBITDA. Banks use these financial covenants to keep a company from over-borrowing.
In some cases, the bank might instead set a minimum Tangible Net Worth amount that the company must maintain. Regardless, the purpose of this covenant is to keep a company from increasing its borrowing to a risky level.
Loan covenants are included in bank documents to help protect the lender from loan losses. Because of increased banking regulations and oversight, local bankers may be unable to forgive or waive loan covenant violations. Even financially strong businesses that provide late financial statements or repeatedly miss financial covenants, even slightly, can be adversely impacted by their failures.
As a borrower, businesses have a contract with their bank as defined by the loan documents. Failing to satisfy conditions of that contract can cause a loan default, so it is important to fully understand all loan covenants and whether they are being met.