Understanding Loan Covenants

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By: Wilmington Trust

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 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.

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.

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.

Types of Loan Covenants

Debt-to-Worth Ratio. Sometimes called a Leverage Ratio, this benchmark is a measure of your business' total liabilities divided by its total shareholder value. A ratio of 1.5:1 indicates that for every dollar of equity in a company, there also exists $1.50 of debt.
Debt Service Coverage Ratio. This is a cash flow measure that reflects a company's ability to service its debt obligations (generally calculated as a company's net cash flow during a specific period divided by its required debt service during that period). A calculation of 1.20x, for instance, indicates that for every $1 of debt service that a company is responsible for in a given period, it has $1.20 in net cash to service it. This is a good measure of a company's cash flexibility in meeting its debt obligations. Banks prefer a cushion and often require a covenant equal to or greater than 1.20x.
Working Capital. Working capital is defined as those funds invested in a company's cash, accounts receivable, inventory, and other current assets, and it is calculated by subtracting current liabilities from current assets. Working capital finances a company's cash conversion cycle, which is the time required to convert raw materials into finished goods, finished goods into sales, and accounts receivable into cash. A minimum working capital covenant ensures that the borrower exercises prudent balance sheet management and maintains adequate flexibility to meet interim cash needs.

Updated: January 1, 2013

This article is for informational purposes only and is not intended as an offer or solicitation for the sale of any financial product or service or as a determination that any investment strategy is suitable for a specific investor. Investors should seek financial advice regarding the suitability of any investment strategy based on their objectives, financial situations, and particular needs. This article is not designed or intended to provide financial, tax, legal, accounting, or other professional advice since such advice always requires consideration of individual circumstances. If professional advice is needed, the services of a professional advisor should be sought.
© 2013 Wilmington Trust Corporation.

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