In business, trust is important, but clear, mutual expectations of any relationship are essential. When your business needs to borrow, you need to trust your lender and understand how your lender ensures that you will repay your loan.
Covenants are the guardrails of a loan. By agreeing to a loan covenant, both sides state their intentions: the borrower promises to stay financially sound for the term of the loan, and the lender states its expectations for the borrower’s debt and capital structure during the loan payback.
Before you take out a loan, there are a few things you should know about loan covenants, so you can establish your business as a reliable lending partner.
Adhering to covenants can protect your business
Loan covenants are designed to protect the earning assets of the borrower, ensuring your business can generate the revenue necessary to repay the loan. Covenants are stipulations that you, as the borrower, agree to. They require you to fulfill certain conditions or prohibit you from taking actions. They ensure that your business does not overextend itself or implement a strategy that may be harmful to or disrupt its business. There are two kinds of covenants: quantitative and qualitative.
- A quantitative loan covenant may require a borrower to maintain a certain debt-to-worth ratio, a measure of equity in the business compared to outstanding debt. Or it may stipulate that a borrower cannot exceed a certain debt-to-worth ration. It also may require the borrower to maintain a certain ratio of cash to total assets.
- A qualitative loan covenant may require the borrower to provide financial statements within 10 days of the close of each quarter. Or it may say that the borrower may not incur additional debt from another lender without their prior consent.
Communication makes covenants work
Violating a loan covenant will result in the borrower being penalized or the lender calling the borrower’s loan into default.
It’s not always negligence on behalf of a business that results in a covenant being violated. Sometimes a covenant may be tripped by unforeseen events, such as a flood that necessitates a large expenditure to get the business back to normal, a hurricane that prevents product from being shipped or any other unexpected cost that may cause a shutdown or interruption in the business operations.
Another common pitfall occurs when a business grows rapidly, causing its debt-to-worth ratio to rise from buying new materials or incurring larger labor expenses. In those instances, lenders can be flexible. For example, with a fast-growing business, a banker may be able to overlook a covenant violation for the prospect of having a larger, more profitable business to work with.
Keep in close contact with your lender if you think a covenant may be breached.
Covenants are typically set quarterly to keep them from being triggered by monthly variation. Depending on the circumstances, covenants are usually set high enough, so that the borrower has some flexibility.
Loan covenants allow both parties to have a clear understanding about the rules related to borrowing. Think of a loan covenant as an early warning device and a clear statement of what is considered in and out of bounds by the lender. Structured properly and followed closely, loan covenants avoid payment problems and will ensure smooth and timely repayment of the debt.