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Know your Covenants

Banks put covenants on customer accounts to prevent certain actions and to serve as an early warning mechanism in a firm’s financial status.

Covenants can be financial or non- financial.  Non-financial covenants typically prohibit certain actions by the company such as paying dividends to owners while the loan is outstanding.  A clause prohibiting a change of ownership without the bank’s permission is also typical.  Other normal covenants require insurance coverage for collateral, timely financial information, covenants that require a company to pay all payroll and income taxes on time, and that you not violate laws such as environmental regulations.

Financial covenants focus on your ability to pay back the loan, liquidity or cash flow covenants and leverage ratios.  Leverage ratios restrict the company from obtaining additional financing.  An example of a leverage ratio is a debt-to-net worth ratio.  Your bank will want the owners to have an investment in the firm so they require that debt not exceed a percentage of the net worth.  Since profits increase net worth and losses eat into net worth as the firm accumulates undistributed earnings, the debt-to-net worth ratio declines (improves).

Liquidity or cash flow ratios are intended to ensure that the borrower has cash flow to repay the loan.  A typical cash flow covenant is a fixed charge coverage ratio.  The bank will want the company to have more cash flow than its fixed charges.   Fixed charges may include interest expense, lease and rent payments.  The ratio is typically earnings before taxes and fixed charges divided by fixed charges.  (EBT + Fixed Charges / Fixed Charges)  The lender may adjust the definition of fixed charges to match the nature of your business.  Some lenders exclude depreciation from earnings but all include spending for capital equipment in fixed charges.

Banks normally require financial reports each quarter and will include a calculation of each covenant.  There will be a certificate from the owner or an officer certifying compliance with the covenants included in the reporting package.

Violating a covenant can result in an early repayment clause calling the loan and seizing collateral.  But that doesn’t necessarily happen.  The loan may allow for a cure period during which the owners can fix the problem.  The violation must be disclosed to the lender as soon as it is known and the plan of correction should be presented at the same time.  Depending upon the nature of the violation, the bank may reset the covenant, require an additional fee, increase the interest rate or take other steps that allow a continuing relationship with more bank involvement and a higher return for their higher risk.

Your financial reports should compute all loan covenants every month and your forecasting process should also project compliance with all covenants.

A B2B CFO® partner is an excellent ally in bank negotiations who can help you understand the proposed terms and negotiate with lenders.   A B2B CFO® can also train your staff in covenant calculations so you have an early warning system.

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