A loan covenant is a clause in a loan agreement that stipulates specific parameters the borrower must adhere to. These can be things the borrower must refrain from or certain conditions they must fulfill.
Virtually all bank loans come with a loan covenant, and failure to comply may lead to serious consequences. These can include incurring huge fines from the lender or even liquidation of your collateral.
Here is a detailed look at this often-ignored clause in loan agreements.
The Purpose of a Bank Loan Covenant
Bank underwriting criteria are notoriously stringent. Loan covenants allow a borrower to map out their loan repayments way before they fall due. Failure to adhere to stipulations outlined in the covenant can cause the lender to take action against you.
While covenants might be seen to serve the interests of the lender, they encourage practices that are vital for the success of enterprises. For example, maintaining the right financial ratios can improve the operational efficiency of your business.
Types of Loan Covenants
There are three types of covenants; financial, affirmative, and negative loan covenants.
1. Affirmative Covenants
These are also referred to as positive loan covenants. They outline things a borrower must do as they make their repayments.
Some of the stipulations are pretty basic.
Paying taxes, maintaining a positive cash flow, taking out business insurance, accurate record-keeping, and maintaining collateral are examples of affirmative covenants.
A lender might go a step further and require a business to maintain certain financial ratios.
The more common ones here include:
Debt to Equity Ratio
Debt and equity speak to how an enterprise finances its operations. This ratio can be used to measure the risk that a business will be unable to meet loan repayments.
The debt to equity ratio shows a businesses’ debt as a percentage of its equity. A company whose ratio is less than 1:0 is less risky than one whose ratio is above 1:0.
Debt to Asset Ratio
This ratio shows the percentage of a company’s assets vis a vis its debts. It is, therefore, an indicator of a company’s financial leverage.
The higher the ratio, the higher the degree of leverage, and the riskier a business is deemed to be. In other words, a highly leveraged company has increased chances of defaulting.
For this reason, a lender might stipulate a ratio that a business should hold to prevent default.
Net Working Capital
This gives a representation of the assets and cash reserves a business holds after covering liabilities.
Net working capital shows what a company has at its disposal to invest in profit-making ventures. A positive net working capital is desirable, and some lenders might demand this.
But take care because a high working capital might indicate an inability to invest excess cash or holding too much inventory.
2. Negative Covenants
Negative or restrictive covenants bar the borrower from taking certain actions during the loan repayment period.
The terms stipulated in this manner cannot be broken. However, the business can seek permission or approval from the bank to bypass them.
Breaching these terms can be regarded as a technical default, and is seen to be increasing the risk of non-payment. This is true, regardless of whether or not a business is meeting its loan obligations.
Technical defaults can also lower credit rating and stock price. There are several types of negative restrictions.
Asset Related Restrictive Covenants
These place restrictions on the borrower’s assets. Some of these stipulations include:
- Creating additional charges on assets
- Selling fixed assets
Liability Related Restrictive Covenants
These restrict activities that can affect a company’s liabilities. They include:
- Repayment of existing loans and taking up new loans
- Issuing of additional equity shares
- Issuance of loans and deposit certificates
Cash Flow Related Restrictive Covenants
These restrict cash flow usage, including:
- Dividend payment
- Capping top management salaries and benefits
- Limiting expenditure on new projects, including diversification, modernization, expansion, and so on
3. Financial Loan Covenants
These place oversight on whether or not a business is reaching the estimates provided to the bank. If a business is constantly missing the mark, it is likely to raise a red flag.
To protect themselves, many lenders will peg loan amounts to a business’s performance.
What Happens if You Violate a Bank Loan Covenant?
If a business breaches a loan covenant at any point, the lender has multiple remedies that include going to court.
However, some lenders will offer deadline extensions for submissions, waivers, debt buybacks, and amendments. But stringent measures such as liquidating collateral and pushing for insolvency are not out of the question.
Banks can also move to amend your loan terms to shift it to a more asset-based scenario. This can involve pushing for a personal guarantee, including attaching your home to the loan.
There is no guarantee that the bank will act in any particular way. While most lenders will want to find an amicable solution, it is not unheard of for some lenders to take advantage of the situation to take hold of a business’ assets.
What to do as a Business Owner to Make Sure You’re Monitoring Loan Covenants
As we have seen, breaching your loan covenant can get your business and personal finances in serious trouble.
This makes it imperative to keep a firm handle on your loan covenants. Read your loan offer document carefully and consult an attorney if you need further clarification.
This will help you not only understand what to do but also, to understand the restrictions and how these play out in your larger business strategy.
Right off the bat, ensure that you alert your bank if you sense a breach coming on or identify one that has already occurred. This is your best bet at reevaluating your situation with your banker and finding solutions with minimal interference to your business.
Should you, despite your best efforts, get a letter of default, technical or otherwise, do not panic.
Your bank will generally want to resolve matters with you to increase their chances of fully recovering their debt.
The default letter will usually come with solutions, the bulk of which are typically stipulated in the “remedies” section of your loan agreement.
Bank loan covenants are, in many cases, not avoidable. However, they are not enough reason for you, as a small business owner, to stay away from a bank loan. But it is important to understand all the conditions laid out before agreeing to the terms of a loan.