With greater attention being paid to the details of commercial lending, we get asked more and more about loan covenants. Loan covenants are conditions a borrower agrees to comply with when accepting a loan from a bank. Loan covenants are put in place to ensure the bank has a continual understanding and report of business condition and actions. It is important for a business to comply with loan covenants as failure to comply can put the loan into default.
Banks usually put loan covenants in place to accomplish the following:
Maintain Loan Quality,
Keep adequate cash flow,
Preserve equity,
Maintain an updated picture of the borrowers financial condition.
Some common loan covenants are:
Maintenance of adequate Hazard and Content Insurance coverage,
Key Main Life Insurance,
Payment of income and property taxes, fees and licenses.
In addition to these types of covenants, lenders also add covenants that ensure borrowers maintain certain key financial ratios.
These include:
Minimum Quick and Current ratios, which demonstrate liquidity,
Minimum Return of Assets and Equity, which demonstrate profitability,
Minimum Working Capital, Equity and Maximum Debt to Net Worth, which demonstrate leverage.
These financial indicators and ratios are checked annually when a lender reviews financial statements and tax returns.
Lenders will also have loan covenants that restrict borrowers from doing things that may be detrimental to the condition of the business.
These may include:
No change in management or merger without prior approval,
No additional loans without prior approval,
Limited dividends and owner withdrawals.
The more mature the relationship between the lender and the borrower, the less need there may be for loan covenants. The covenants are listed in the loan agreements between the business and the bank. A business should review these covenants with their banker and their legal counsel prior to moving forward with a loan agreement. It is important that the business owner is aware of these covenants, as they must be complied with. Banks use the loan covenant to ensure the original conditions they provided financing under are maintained and that any negative changes to these conditions are uncovered before it is too late.
