Banking and Financial Services Sections

Ignorance Is Not Bliss

Keys to Understanding and Negotiating Bank Covenants

Kristi Reale, CPA, CVA

Kristi Reale

Most commercial-loan agreements contain what are commonly referred to as financial covenants. These covenants often serve as an early-warning system to alert both the lender and the borrower that the business might not be headed in a positive direction.
Knowledge of how these covenants are constructed and why they might be included is very important in negotiating an effective loan agreement.
Covenants typically break down into three classifications: affirmative or positive, restrictive or negative, and financial. What follows is a review of these covenants and some of the language attached to them, as well as some answers to many of the common questions that business owners and managers have about these terms and conditions.
Affirmative or positive covenants are standards and requirements the borrower must meet while the business loan is outstanding. Examples include maintaining the proper level of insurance coverage, paying taxes in a timely manner, maintaining a checking account with the lender, submitting financial information to the lender, or maintaining the business.
Restrictive or negative covenants are requirements that limit the borrower’s actions in favor of the lender. Examples include limiting capital-acquisition purchases, restricting dividends or stockholder distributions, limiting owner compensation, or preventing new borrowings from other lenders.
Financial covenants are usually derived from common ratios and other metrics based on the balance sheet, income statement, and statement of cash flows, and require the borrower to maintain certain liquidity or performance ratios. Some of the most common are:
• Debt-to-equity ratio: This ratio, sometimes called a leverage ratio, is a benchmark of a business’ total liabilities divided by its total stockholders’ equity. This ratio highlights how much the owners have at risk (equity) vs. the lenders (liabilities). A ratio of 1.5:1 indicates that, for every dollar of equity in a company, there also exists $1.50 of debt.
• Debt-service ratio: This ratio is a cash-flow measure that reflects the borrower’s ability to service its debt obligations. It is usually calculated as a company’s net cash flow divided by its required debt service during a given period. A calculation of 1.2x indicates that, for every $1 of debt service (principal plus interest) a company is responsible for in a given period, it has $1.20 in net cash to service it. This is often a good measure of a borrower’s cash flexibility in meeting debt obligations.
• Working-capital ratio: This ratio is defined as those funds invested in a company’s cash, accounts receivable, inventory, and other current assets, and is calculated by subtracting current liabilities from current assets. Working capital finances a company’s cash-conversion cycle, which is the time required to convert raw materials into finished goods, finished goods into sales, and accounts receivable into cash. A positive working-capital covenant ensures that the borrower exercises prudent balance-sheet management and maintains adequate flexibility to meet interim cash needs.

Can You Negotiate Covenants with
Your Lender?
If your company is strong financially, you are in a better position to negotiate loan covenants with your lender when you are applying for a new loan. Lenders utilize covenants to minimize their risk and protect their interests; however, a lender would not be making a loan to your business if it did not want your business to succeed.  Have a clear idea of where your strengths lie, and negotiate your covenants accordingly.
By submitting a well-developed business plan and having an honest discussion with them about your business, you might be surprised by how willing a lender will be to work with you.

Know What You Are Signing
Ignorance is not bliss when signing a loan agreement, so make sure you carefully read your loan document and understand what you are agreeing to. If you do not understand a covenant or how it is calculated, you should seek out professional guidance, as once you sign that document, you are bound by the terms and conditions of the loan agreement regardless of your understanding.

Monitor and Communicate
Do not wait until the end of the year to look at your covenants. Create a proactive system to monitor progress on all financial loan covenants. Covenants should be reviewed at least quarterly. Update your internal projections through the end of the year and calculate whether you will be in compliance.
If you determine that a covenant breach is apparent, you should contact your lender as soon as possible. Be open and forthright with your lender, as they do not like surprises. Set a meeting; bring your calculations, projections for the remainder of the year, and a realistic recovery plan for the future. The lender is now aware of a possible breach that could occur, and the conversation will be calmer than one conducted at the last minute. A well-informed lender may be willing to change the terms of your loan to your benefit.

What If I Do Not Pass?
Once you realize that you will not be in compliance with the covenants, you will need to notify your lender in writing and request a covenant-waiver letter. This letter basically acknowledges the non-compliance, and the bank then waives the company’s compliance for the period in question.
A covenant breach is a technical violation of the loan document, and allows the lender to take any action legally available under the terms of the loan agreement. One of the most severe actions is to call the loan and terminate the relationship; though not the most common action, it is a possibility.
More often than not, the lender will charge you a penalty for a covenant breach. These penalties can be an increase in the interest rate paid or a one-time monitory penalty. You can attempt to negotiate the penalty with your lender; however, once the covenant is breached the power shifts to the lender.

In Conclusion
It is very important for business owners to fully understand loan-covenant issues in today’s tight credit environment. Failure to do so can place your organization at significant risk. Maintain a healthy and open communication with your lender.
Remember, they would not be willing to loan you money if they did not want your business to succeed. Be prepared to negotiate with a detailed plan of action, and utilize outside professionals such as independent certified public accountants to ensure that covenants are fair, achievable, and address your company’s needs. Your CPA and your banker can be valuable resources in structuring your loan to be the most advantageous to all parties.

Kristi Reale, CPA, CVA is a senior manager with Meyers Brothers Kalicka, P.C. in Holyoke. In addition to the tax, accounting, and consulting services she provides clients, she is also a certified valuation analyst; (413) 536-8510.

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