In business, trust is important, but insurance is essential. When your business needs to borrow, you want to know you can trust your lender and that you understand its expectations for when and how you will repay the loan.
Loan covenants act as that insurance. 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 outlines its expectations for the borrower’s debt and capital as the loan is paid back.
Before you take out a loan, here are a few things you should know about loan covenants so you can establish your business as a reliable lending partner.
Covenants can protect your business—so long as you understand them
“By and large, covenants are really designed to protect the earning assets of the borrower,” says Dev Strischek, senior vice president and senior credit policy officer at SunTrust Bank.
Generally speaking, Strischek says loan covenants either require a borrower to do something or prohibit the borrower from doing something. Also they come in two kinds: quantitative and qualitative.
A quantitative loan covenant might require a borrower to maintain a certain debt-to-worth ratio, a measure of equity in the business compared to outstanding debt. Or it might stipulate that a borrower cannot exceed a certain debt-to-worth. It also might require the borrower to maintain a certain ratio of cash to total assets.
A qualitative loan covenant, on the other hand, might require the borrower to provide financial statements within 10 days of the close of each quarter. Or it may say that the borrower cannot incur additional debt from another lender without the prior consent of the bank.
“One way or another, they’re there to make sure that the borrower doesn’t sell off his equipment—as an example—that he needs in order to make his product or provide his services,” Strischek says. “They’re designed to keep the borrower out of trouble.”
Communication makes covenants more effective for you
Violating a loan covenant can result in the borrower being penalized or the bank 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 snowstorm that prevents product from being shipped or other unexpected costs that cause a shutdown or interruption in the company’s operations.
Another common pitfall occurs when a company grows quickly, causing its debt-to-worth ratio to be skewed since it may be buying lots of new product or incurring hefty salary or wage expenses. “Sometimes it’s just growing so fast that it sort of outstrips the covenant,” Strischek says.
In those instances,and depending on the circumstances, lenders tend to be flexible. For example, in the event of a fast-growing business, a banker might be inclined to overlook a covenant violation in lieu of the prospect of having a “bigger, more profitable company to work with.”
That’s why it’s critical to keep in close contact with the bank if you think a covenant might be breached.
Strischek says banks tend to set quarterly rather than monthly covenants to give the borrower time to get his or her financial house in order. Also, he says, depending on the circumstances, banks tend to set covenants high enough so the borrower has some room to breathe.
In many ways, loan covenants allow both parties to have a clear understanding about the rules of the road related to borrowing. After all, it’s in the best interest of both the bank and your business that a loan repayment is consistent and easy.
As Strischek puts it, a loan covenant acts much like the rumble strips on the side of a highway, ensuring that the driver knows what’s considered in and out of bounds. “Covenants are like those strips—they wake you up before you get yourself into trouble.”