Any loan agreement negotiated between a lender and a borrower is likely to come with a list of stipulations known as debt covenants. These are requirements and conditions imposed by the lender that the borrower promises to abide by until the loan is repaid.
What Is a Debt Covenant?
Debt covenants are conditions imposed by a lender in a loan agreement that limit certain actions of the borrower. They are agreements between the debtor and creditor that the company will operate within the rules established by the lender as a condition for receiving the loan.
The covenants are generally two types: positive and negative.
Positive covenants state something that the borrower must do. As an example, a covenant might require that the borrower must always maintain a certain minimum level of working capital or keep financial ratios within specified ranges.
Negative covenants are borrower’s actions that the lender prohibits. The agreement, for instance, might prohibit the borrower from using company funds to acquire another company.
What Are the Purposes of Debt Covenants?
Debt covenants are intended to bring together the common interests of the borrower and lender. They are not meant to place unnecessary burdens on the borrower or hinder the operations of the business.
They identify the “red flags” that will be used to indicate problems in a business that might impair its ability to repay a loan.
Debt Covenants Examples
A lender wants to feel comfortable that the borrower will be able to repay the loan under the agreed terms.
The lender does not want the debtor to become too highly leveraged financially by taking on more debt or incurring more loan payments than the company’s cash flow can handle.
Some examples of restrictive ratios that may be imposed by lenders are as follows:
- Debt payments/Earnings before interest, taxes, depreciation and amortization (EBITDA): This ratio is key for lenders. It is calculated by dividing EBITDA by the annual debt service, principal plus interest payments, of the loan. A ratio of 3:1 is usually a good ratio to have. Anything less and a borrower could begin to have problems meeting the debt obligations.
- Interest Coverage Ratio: This ratio is calculated by dividing EBITDA by the interest payments on loans. It should be in the range of 3 to 4 times for adequate coverage. It does not include any allowance for principal payments.
- Debt/Equity: This is the ratio of total debt to a company’s equity capital base. Lenders are generally comfortable with $1 in debt for each $1 in equity. In some industries, higher debt ratios are acceptable.
- Debt/Total Assets: This ratio tells how much of a company’s assets are financed by creditors. In this ratio, debt includes short- and long-term loans plus all current liabilities.
- Tangible Net Worth: Tangible net worth is the net worth of a company excluding intangible assets such as intellectual property, patents and copyrights. It represents the physical assets of a company.
- Dividend Payout Ratio: Shareholders cannot suddenly decide to pay themselves large dividends and leave nothing for the creditors.
- Current ratio: All businesses need an adequate amount of liquidity to pay vendors, purchase supplies and meet payroll. A ratio of $2 in current assets for each $1 in current liabilities is good.
Examples of Positive Covenants
These are a few typical positive covenants:
- Present financial statements annually within a specified time frame: Lenders will require financial statements to make sure the company is in compliance with the debt covenants.
- Make sure certain financial ratios stay within a specific range: Ratios are key performance indicators for liquidity, debt leverage and profits.
- Maintain life insurance policies on key employees: Certain employees, such as a sales manager or production supervisor, are essential to small businesses, and their loss could cause a serious setback for the company.
- Keep all facilities in good working condition: Companies that don’t take pride in their property and equipment are typically inattentive to other aspects of their business.
- Pay all property and income taxes on time: Tax liens can take precedence over lenders’ loans.
- Maintain property insurance and a reasonable amount of liability insurance: A disastrous uninsured loss from a fire or flood could ruin the business and wipe out any chance to repay creditors.
Examples of Negative Covenants
These are examples of negative restrictions:
- Not incur additional debt: Lenders do not want the company to become too highly leveraged.
- Not make a change in ownership: Owners of small businesses are the founders and creators of the company, and the loss of any of them could be devastating to the survival of the business. Any changes in ownership would need the lender’s approval.
- Not enter into certain types of lease agreements: Lease agreements require payments, and additional payments would put more burdens on the company’s cash flow.
- Not sell certain assets: If a business gets tight on cash, the lenders don’t want the company to start selling assets to meet loan payments.
- Not make loans to insiders or affiliates: Lenders see insider loans as an underhanded way to take cash out of the business.
- Restriction on mergers and acquisitions: Lenders don’t want owners making major changes to the core business. It could be too disruptive.
Actions For Violations of Debt Covenants
The consequences for violating the debt covenants can be severe; here are a few actions that lenders might take:
- Request an increase in the amount of collateral
- Raise the interest rate
- Impose immediate penalty payments
- Terminate the loan agreement
- Accelerate the loan and demand immediate repayment
If a borrower is having problems meeting loan payments and is becoming non-compliant with the debt covenants, the best course of action is to meet with the lender and ask for waivers. Lenders are not anxious to call their loans for immediate payment and would more than likely be willing to work out the situation.
Foreclosure would be a loss for everyone.
How Do Debt Covenants Benefit the Borrower?
Debt covenants are not always just for the benefit of the lender; they also benefit the borrower.
Negotiating a loan agreement with a lender can be a learning experience for borrowers who do not have financial backgrounds. By going through the debt covenants, the borrower will better understand how to manage a successful business for solid financial growth.
The positive and negative covenants imposed by lenders tell borrowers which financial indicators they should be looking at in the operations of their businesses. If the lenders think a certain ratio is important, the borrower should also see it as important and understand why.
Lenders aren’t trying to inhibit a company’s growth and don’t want to penalize its operations. On the contrary, lenders want a business to become more successful because that improves their chances of getting the loan repaid and the possibility of making future loans. In this sense, the interests of creditors and borrowers are the same.
Borrowers benefit from debt covenants by receiving lower borrowing costs. When borrowers agree to certain restrictions in a loan, lenders are willing to reduce interest costs and fees because their risks are reduced.
How Do Debt Covenants Benefit the Lender?
Debt covenants protect lenders by restricting specific actions by borrowers that could have adverse effects or increase the risks for the creditor.
Covenants create “safety nets” to provide security for loan repayments in the event of adverse results or economic downturns.
Borrowing money is usually a stressful process for small business owners, but it doesn’t have to be. It can be a learning experience that owners can use and implement in their company to build a solid financial foundation and grow the business.