By Ian Coddington
You may be a business owner looking to expand into a new market, purchase new equipment, or conduct development on a new product or design, but don’t want to use cash from operations. How do you complete this? One of the most common ways to fund these kinds of ventures is through financing, specifically debt financing. To effectively use debt, you need to understand covenants, which may be included in the loan agreement.
This article will help you understand what are covenants and why are they required, how covenants might affect your business, and managing your covenants.
“Using debt can be an effective way to expand your business, and by understanding the intricacies of bank covenants, you can make better decisions as a business owner.”
Using debt can be an effective way to expand your business, and by understanding the intricacies of bank covenants, you can make better decisions as a business owner.
What Are Covenants, and Why Do You Need Them?
Simply put, a covenant is a restriction. When a bank or financial institution underwrites a loan or issues a line of credit to a business, they take on a certain amount of risk.
How likely is the business going to pay in a timely manner?
Will the business pay back the loan?
How volatile is the company’s industry?
What is the collateral for the potential loan?
These are all questions lenders will ask and need to understand before issuing a loan. To protect their investment, the financing may require financial covenants. First, there are positive covenants; for example, you are required to have up-to-date insurance coverage and meet certain ratios. It might sound odd to call these positive, but these are items the bank wants to ensure you have in place to help protect the business.
Negative covenants act in the opposite way. Often times, the bank does not want the company taking on other debt obligations without the bank’s prior approval or until the most recent debt is paid off. In addition, negative covenants are often structured to look at a company’s solvency and not violating financial metrics. These are built into the financing to protect the bank, but also to protect the company and the business owner.
Some of the most common financial ratios and metrics that banks look at for assessing a loan are:
Leverage ratio: cash flow from operations divided by total debt. This ratio measures the number of years to pay off of a debt obligation, the lower the better.
Debt service coverage: net operating income divided by total debt service. This ratio measures the ability to service the current debt. The higher the ratio, the greater the ability of the borrower to repay.
Quick ratio: cash and equivalents, marketable securities, and accounts receivable divided by current liabilities. This ratio tests the ability of a company to pay its current liabilities when they come due with its most liquid assets. A strong quick ratio indicates the company will be able to pay its long-term obligations without needing to sell long-term assets.
How Covenants Might Affect Your Business
So you have met with a lender, gone through the approval process, and have your new loan right in front of you. Are you ready to sign it? Make sure you review any financing agreements or amendments with your attorney and accountant. Depending on the type of loan, it could require a compilation, review, or audit-level financial prepared by a CPA.
Financial preparation ranges in complexity: the more complex, the more intrusive and costly. Going from a review-level financial statement to audited financial statements could double your accounting fees that you already pay. This could come as an unwanted surprise if you are not ready for it.
There are changes on the horizon. As bankers look at new loan agreements or new amendments to current loans, be aware of the adoption of new lease accounting standards by the Financial Accounting Standards Board. Companies are not required to implement the new standard until years beginning after Dec. 15, 2021 (effective for fiscal years ending Dec. 31, 2022). This new standard could impact the definition or calculation of specific covenants.
Managing Your Covenants
You don’t want to wait until the end of the year to evaluate and determine the company’s overall position of compliance with negative and positive covenants. If you find yourself in a situation of continuously failing your covenants, your overall relationship with a bank might be impacted. To help alleviate this, a company should conduct tax planning and/or obtain advice during the year.
Debt is a great tool in a business owner’s toolbelt to grow their business. By understanding the restrictions, or covenants that a lender might use, you can make a more informed decision about whether debt financing is right for you. You also might use a professional to plan around your new debt to foster a healthy relationship with the bank. Strong creditors lead to happy lenders, which leads to better business for everyone.
Ian Coddington is a senior associate with the Holyoke-based accounting firm Meyers Brothers Kalicka, P.C.