Loans generally come with covenants that serve as protections for the lender to ensure that the borrower meets certain levels of financial strength and performance. There are a variety of ratios or calculations that can be used, but in general they are all designed to predict your ability to repay your loan. The most common types are asset-to-liability ratios such as the current ratio, or income-to-financing costs such as the Fixed Charge Coverage Ratio. The types of ratios used are pretty standard, but the minimum or maximum restrictions vary and may be open to negotiation.
They are generally reported quarterly to the bank. For internal purposes, they should be reported more frequently and should be forecasted at least two quarters in advance. This will allow time to arrange alternatives in the event that your forecast falls out of compliance with the covenant restrictions.
Covenants are generally designed to change over the life of the loan, and can be adjusted later as well if your situation changes. The loan documents generally contain language that specifically spells out events of default as well as how each covenant is to be calculated. Take the time to study the language so you completely understand it.
- Be aware of the covenants before closing the loan. That’s the best time to negotiate as much flexibility as possible for your company.
- Create an easy to use template to calculate the covenants and report them to the bank as required. Be aware the covenants change over the life of the loan, so build those dates and changes into the template.
- Build covenant calculations into your financial forecasts. Predict and internally report covenant compliance at least two quarters in advance. Graphics and conditional formatting help to highlight potential non-compliance issues.
- If your business is going through significant changes that may affect your ability to stay in compliance with covenants, consider going back to the bank to attempt to have them adjusted.
- Understand the events of default, including any events that can occur even if you are in compliance with the covenants, and have a plan in place to deal with it long before you need it.
Those are the ins and outs of financial covenants. If I left anything out, please add your comments below.