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Are Your Loan Covenants Keeping You Up at Night?

Alerus | JAN 04, 2018

The quest for capital seems to many business owners like it never ends. Just keeping the business running, let alone growing, requires a stable source of funds now and in the future. For most business owners, that means financing of some type becomes necessary at certain points in the company’s life cycle.

When you borrow money (whether it’s a loan or a line of credit), you sign many documents, and it is important to realize that those documents contain items called covenants. Think of covenants as promises the borrower makes, committing the borrower to do certain things and not do certain other things. 

The purpose of covenants is to help lenders protect themselves from borrowers defaulting because of actions harmful to themselves or the business.

Common Covenant Examples
Quite often, business owners are so delighted and relieved to have access to the cash made available by the lender that they don’t spend enough time reading the documents and asking questions. That can lead them to sign papers containing terms that, later on, can lead to some sleepless nights.

1. Debt Service Coverage Ratio Covenant

Also known as a cash flow covenant, the debt service coverage ratio is the most common type of loan covenant. The idea is to ensure that the business is generating enough cash flow to comfortably service the debt. 

For example, a bank may set a debt service coverage ratio of 1.25, which means the bank expects to see the business generate $1.25 in cash flow for every $1.00 in debt service. Another way to think of it is that the company’s net operating income for a given period must exceed total debt payments owed to the bank during that same period by 25 percent. If the total debt payments during the period were $100,000, then the company would need to generate $125,000 in income to comply with the covenant.

2. Liquidity Covenant

Liquidity covenants require the business to maintain a certain level of cash resources. Frequently, companies with initially high levels of liquidity are able to choose from a range of covenant levels, while companies with lower levels of liquidity won’t have as many choices.  Examples of liquidity covenants include minimum cash on hand, working capital ratio (current assets divided by current liabilities), and the quick ratio (current assets minus inventories, divided by current liabilities).

3. Leverage Covenant

The leverage of a borrower is the ratio of debt outstanding compared to cash flow. Lenders will accept different amounts of leverage based on a variety of factors, such as the business cycle, quality (predictability) of cash flow, business projections, and the quality of the secondary form of repayment. Lenders look at the business’ leverage ratio and will require that ratio to be at or above a certain level. The most common leverage ratio is the ratio of debt to EBITDA (earnings before interest, taxes, depreciation, and amortization). 

Talk, Negotiate, and Understand
What we have just discussed is only a handful of the possible covenants that could become part of a loan or line of credit. It is very important for borrowers to take the time to:

  • Read all the loan documents before signing, and get legal advice if needed.
  • Have open conversations with your lender - never be afraid to ask questions.
  • Be confident about negotiating with the lender. Some terms may be able to be modified, but you'll never know if you don't raise the question.

 

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