Page 25 - BusinessWest October 17, 2022

Growing Concerns
What You Need to Know About Bank Covenants
YBy Ian Coddington
ou may be a business owner looking to
expand into a new market, purchase
new equipment, or conduct develop- ment 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
cacies 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 busi- ness, they take on a certain amount of risk.
How likely is the busi- ness going to pay in a timely manner?
Will the business pay back the loan?
How volatile is the com- pany’s industry?
Negative covenants act in the opposite way. Often times, the bank does not want the com- pany 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 sol- vency 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
“Using debt can be an effective way to expand your business, and by under- standing the intricacies of bank cov- enants, you can make better decisions as a business owner.”
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 cov- enants might affect your business, and managing your covenants.
Using debt can be an effective way to expand your business, and by understanding the intri-
What is the collateral for the potential loan?
These are all questions lenders will ask and need to understand before issuing a loan. To pro- tect their investment, the financing may require financial covenants. First, there are positive cov- enants; 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.
due with
Covenants
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