Profits On Purpose | 5 Things You Must Know About Loan Covenants
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5 Things You Must Know About Loan Covenants

We’ve closed several commitments for lines of credit, term loans and mortgage loans for equipment and real estate.   When reviewing your term sheets or commitment letters, after you go through the borrower, loan amount, rate and fees, collateral and guarantor section, you’ll end up at a section called covenants. A covenant is a mutual promise made by both parties, you and the bank. In this section, both parties agree to certain things as conditions of the borrowing relationship. If either party breaks the covenant, then both parties come to the table to discuss what happened and why. Here are five things you must know about loan covenants.

1. The most common types of covenants are financial covenants. Financial covenants generally fall in to ratios pertaining to the balance sheet and income statement. The most common income statement covenant is called a cash flow coverage ratio, debt coverage or fixed charge coverage ratio. It’s important to understand how this ratio is calculated. It’s mostly, the cash flow of the business (EBITDA) divided by the loan payments made line of credit, term loan or mortgage. Most banks are looking for a 25-50% cushion of cash flow over loan payments, so the ratio is expressed as a cash flow coverage ratio of 1.25-1.50 depending on the lender.

2. The second most common covenant pertains to the balance sheet and is usually a leverage ratio or a debt to worth ratio. This ratio is calculated by dividing total debt by total net worth on the balance sheet. Most banks care about leverage because it shows how much skin in the game the owner has versus his/her creditors. Because the owner has all the upside in the business, banks care if they and other creditors are taking a majority of the risk and have no upside. Generally, if your leverage is much above 3 or 4 to 1, banks may become concerned and could limit your ability to borrow until you get your leverage back in line. It’s common to see at least, one income statement and one balance sheet covenant in your term sheet or commitment letter.

3. The third type of covenants that are common are non-financial covenants. Many banks want annual financial statements within a certain period of time after year-end. If you have a line of credit you may provide monthly financials to the bank including an accounts receivable aging. Most banks will monitor the level of receivables and whether you have any aged receivables or concentrations of receivables that could limit your ability to borrow. Generally, a personal financial statement and personal tax return are part of any financial report covenant requirement also.

4. Many banks will limit the ability to borrow additional funds from another lender as a fourth type of covenant. This is common especially for a business with a lot of leverage. You reduce leverage by increasing net worth without increasing borrowing. There may be situations where borrowing small amounts is in the ordinary course of business. So, it’s possible for you to ask your bank if there’s a maximum amount you could borrow annually without breaking this covenant. $100,000 might be reasonable for a business with $5 million or more in revenue.

5. Changes in ownership and management are the fifth type of covenant banks may require. The bank got comfortable with your loan request based on the majority owners and managers if you have a closely held business. If the owners decide to sell off a significant amount of stock or become absentee owners, the bank may have a different feeling about loaning to your business. They made their decision based on the ability of current management. If there’s a material change, they may feel differently. Before you implement any significant changes in ownership or management, it’s best to get your bank on board and get them comfortable with the reason for the changes and what the changes are.

Let’s agree nobody like surprises. You don’t want the bank to pull the rug out from under you and not renew your line of credit. On the other hand, the bank doesn’t want to be surprised if there have been significant changes in the financial performance of the business or ownership and management changes. Covenants are the bank’s way of saying we don’t want to be surprised. Before you sign your commitment letter, it would be a good idea for you to have a conversation with your bank about how they handle covenant violations if they unexpectedly occur.

Bill McDermott
bmcdermott@mcdfs.com
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