Understanding Loan Covenants

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All businesses, no matter what size, will need to raise money at some point. A small business owner may be able to dip into his or her personal savings, or friends may be able to lend the needed money. Usually, however, people will have to look to outside sources for financing. Before a bank will lend you money, however, it needs to feel satisfied that your business can handle the debt and continue or start to flourish. In addition to analyzing your balance sheet and income statement, a lender may want to tailor the loan agreement to customize the financing specifically for your business.  This is where you need to make sure that it is the right fit for your business.

Almost every loan agreement made with a bank will carry some type of covenant, either restrictive or protective in nature. These can be as simple as requiring that the bank be allowed to view your financial information, or as complex as requiring bank approval for all major financial decisions that you make. Understanding the terms of your loan agreement and any covenants that apply is critical for the business owner contemplating financing.  We suggest that you employ a good financial officer or seek out a consultant that is well versed in this world.

The Loan Covenant
A loan covenant is simply a clause in the lending contract that requires one party (the borrower) to do, or refrain from doing, certain things. A restrictive covenant, for example, may include limitations on what you can do. These limitations often depend, to a great extent, on your company. If the company is a good risk, the limitations will likely be minimal. A higher risk company, on the other hand, will likely have greater limitations. The three principle limitations involve repayment terms, the use of collateral, and periodic reporting. These limitations will generally be detailed in the covenant section of your loan agreement.

Protective covenants, on the other hand, are all actions that you, as the borrower, must agree to. They may include maintaining a minimum level of working capital, carrying adequate insurance, adhering to certain repayment schedules, and supplying the lender with regular financial statements and reports.

Whether restrictive or protective, the loan covenants required by banks are generally associated with the establishment of financial benchmarks and monitoring of your business’ performance against those benchmarks. Commercial loan covenants cover a variety of matters, including working capital, cash flow for debt service, debt-to-equity ratios, or dividend payment limitations. Covenants can be “tested” monthly, quarterly, or annually, depending on a variety of factors. Loan agreements and covenants can also be amended from time to time.

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