Loan covenant definition:

A condition that the borrower must comply in order to adhere to the terms in the loan
agreement. If the borrower does not act in accordance with the covenants, the loan can
be considered in default and the lender has the right to demand payment (usually in full).
Why do banks add covenants to the loan agreements
Banks usually add covenants in order to accomplish the following objectives:
Maintain loan quality
Keep adequate cash flow
Preserve equity
In a borrower with a known weakness in its capital structure as a measure to improve this
weakness
Keep an updated picture of the borrower’s financial performance and condition
Common loan covenants
Things that the borrower must do
Hazard Insurance / Content Insurance
The borrower is required to keep insurance coverage on the plant / equipment or
inventory in order to safeguard against the catastrophic loss of collateral
Key-man life insurance
Insures the life of the indispensable owner or manager without whom the company could
not continue. The lender usually gets an assignment of the policy.
Payment of taxes / fees / licenses
Borrower agrees to keep those expenses up to date as failure to pay would result on the
assets of the company being encumbered by a lien from the government, which would
take precedence to the one from the bank.
financial information on borrower and guarantor
Borrower agrees to submit financial statements for the continuing assessment by the
bank. Financial statements are usually submitted yearly, while account receivable can be
required every month.
Minimum financial ratios
The borrower is required to maintain a certain level in key financial ratios such as:

Minimum quick and current ratios (liquidity)

Minimum Return on Assets and Return on Equity (profitability)
Minimum equity, minimum working capital and maximum debt to worth (leverage)
Other loan covenants
Things that the borrower can not do
In addition, the borrower might be prevented from doing certain things via loan
covenants.
No change of management or merger without prior approval.
Guarantees the continuing existence of your borrower and will impede the deterioration
of financial condition due to merger with an unknown entity
No more loans without prior approval
Assures that the company does not take on excessive debt affecting the quality of the
original loan.
No dividends/withdrawals or limited dividend withdrawals
In situations where the net worth is being eroded by the extraction of capital in the form of
dividends or stockholder’s withdrawals. The lender might find it necessary to restrict the
amount of money that can be taken out of the company. In subchapter-S corporations it is not
uncommon to limit withdrawals to the owner’s tax liability.

the first quarter of 2009, 22% of CPA financial executives said previous sources of credit had
dried up, according to the AICPA/UNC Kenan-Flagler Economic Outlook Survey. As a result,
many businesses are shopping for new loan sources. Consider the following before you talk
to a lender:

Negotiate and monitor ratios. You know your business better than your lender does.
Covenants usually include a loan-to-tangible-net-worth ratio and often quick-and-current
ratios. Banks used to pad ratios by 20% to give the borrower wiggle room, and the borrower
would have to be out of compliance for two consecutive quarters to be in default. “I’m not
seeing those kinds of things being done anymore,” says Sam Thacker of consulting firm
Business Finance Solutions. However, Thacker says ratios can be negotiated upfront. Ed
Lette, CPA, chairman and CEO of Austin-based Business Bank of Texas, says in order to be
prepared for a ratio discussion with potential lenders, look up ratios provided by the Risk
Management Association. Most importantly, track your key financial ratios monthly.

Prepare to be audited. “In the last 12 months we are seeing a trend where smaller
companies are being asked to provide audited financial statements more than ever before,”
Thacker says. Although it is important to consider all costs associated with maintaining loan
covenants, for an unaudited business to provide audited financial statements—especially for
the first time—is a major undertaking that can be very costly. It will take many hours of staff
and management time to formalize accounting policies in accordance with GAAP, train staff,
and set up and test internal controls.

Watch out for a positive cash flow covenant. “One new covenant that I’m seeing is
‘Maintain positive cash flow measured on a quarterly basis,’ ” Thacker says. If your business
cycle is longer than 90 days or you are borrowing against lagging accounts receivable, this
could be an unacceptable covenant for your business.

Get ready for new rate structures. Rate calculation has changed dramatically in the last
six months, according to Thacker. Traditionally, operating loans and lines of credit have used
a prime + X% rate structure. “As prime went down, many lenders put a floor in place,” he
says. Many are also now using the higher of the prime rate as published in The Wall Street
Journal or Libor (the London interbank offered rate).

Be prepared for more stringent “personal guarantees.” The old standard was that
owners who had a 20% or higher stake were required to sign guarantees, Lette said. Now
many lenders require guarantees from 5% owners and even lower, depending on the
company’s structure. U.S. managers of foreign-owned companies are also likely to be asked
to sign personal guarantees.

Know what’s typical. Typical affirmative loan covenants include the requirement to
maintain various kinds of hazard insurance such as property and general liability and to
maintain “key man” life insurance on certain managers. It is common for the lender to require
submission of quarterly or monthly financial statements, the annual corporate tax return and
guarantors’ personal tax returns. Shareholder loans to the business typically must be
subordinate to the loan, and the lender will require you to maintain liquidity and performance
ratios. All taxes and state fees must be paid and kept current.

For operating capital loans, lenders will typically want a monthly report of accounts payable
and accounts receivable as well as copies of IRS Form 941 (payroll taxes) payments and
quarterly 941 filings.
Negative loan covenants typically prohibit: changes in management or a merger without the
lender’s permission; a distribution of profits without prior lender approval; further loans from
other sources without lender approval; an increase on an owner’s annual draw or distribution
without prior lender approval; and the sale of equipment without prior lender approval.

If you are responsible for raising capital, you are probably aware that many banks have
become very strict in the arrangement of loan covenants since the collapse of the housing
market. Breaching, or “tripping,” a covenant can have a devastating effect on any business.
This article explains how to negotiate fair covenants with a banker and offers suggestions on
what to do if a breach is imminent.

COVENANT NEGOTIATION
It is possible to effectively negotiate with your banker, and you should understand how to
appeal to the banker’s best interests. Preparation is a key element in covenant negotiation.
Some finance professionals first see covenants when asked to sign the loan documents, but
they have had no preliminary discussions and believe that covenants are a one-sided
dictation from the bank. In general, this is not true. Although certain covenants must be
expected in a commercial loan, a knowledgeable CPA should effectively negotiate fair and
reasonable covenants.

Before starting any negotiation with your banker, construct a conceptual framework of any
covenant types that might be especially negative to your particular business. You must have a
clear idea where your strengths lie and negotiate your covenants in that direction. For
example, if your business has significantly deleveraged recently but your financial projections
indicate potential losses for the next fiscal year, you would want to mitigate the effect of
income-statement-based covenants by expressing your concerns and suggesting a realistic
cushion in the required minimum or maximum limits. If your business plan requires expansion
based on a mergers-and-acquisitions strategy, you would clearly need to include this as a key
point in negotiations that might include restrictive covenants.

The bank will expect to include covenants that protect its interests. However, bear in mind
that banks want your business to succeed. They prefer to help businesses grow so that their
risks remain low and more loans are requested from the bank. If the CPA can present a well-
conceived business plan and suggest covenants with appropriate limits that contribute to the
success of the plan, most bankers will seriously consider the proposal. You can discuss any
part of a proposed covenant in the give-and-take of a negotiation, but you must be prepared
to offer well-considered and reasonable counterproposals to achieve a positive result.

Covenants should be reviewed collectively to achieve a logical result. Often, restrictive

covenants are interspersed with boiler plate legalese in loan documents. These should be
pulled out and listed together for review. Covenant language in multiple loans with the same
bank should also be examined collectively to eliminate conflicts and unintended
consequences. Take the following steps before entering into negotiations with a banker over
covenants:

Put yourself in the banker’s position based on your understanding of his or her internal and
regulatory demands. Make a list of covenants that you would require if you were the banker.

Develop a specific set of realistic covenants from your perspective. Ask yourself what kind
of covenant structure is reasonable based on your company’s financial position, then
compare it to your business plan to ensure that your proposal does not restrict the company’s
ability to execute effectively.

Begin a hypothetical discussion with your banker about the covenants that should be
included in your next renewal. Stress that your conversation is hypothetical so that the
conversation does not move too quickly into the realm of fact and negotiation. Use “what if”
questions and gauge your banker’s response. Ask a broad range of questions. From this, you
can get a feel for what position the bank will take under certain scenarios.

It can be very difficult to adjust covenants once agreed to, so the key to effective covenant
negotiation lies in preparation before the loan agreement is signed.

Measure proposed covenants against your most recent financials and your best projections.
Look as far into the future as you can reliably project to determine if the covenant you agree
to today will cause a problem in a couple of years based on future losses, equity issues and
so on.

Covenants should also be compared to the near-term and long-term business plan for
possible conflicts to determine if your plans for growth could be subject to restrictive
covenants.

You should carefully gauge your relationship with your bank, and do everything possible to
foster an open and communicative two-way association. Some banks have more Draconian
credit policies than others. It never hurts to know, and talk frequently with, more than one
banker. By developing these diversified relationships, you can better judge the fairness of
proposed covenants.

If your business is in a strong enough financial position to be attractive to other financial

institutions, you should consider additional sources of capital. Credit policy can change
quickly at any bank due to acquisitions, regulatory issues or internal needs. Even if you don’t
think your business is large enough to justify multiple banking relationships, get to know loan
officers at other banks. Tell them about what you’re doing and see if they’ll make competitive
offers.

MONITOR YOUR COVENANTS

One of the most critical aspects of effectively managing any loan relationship relates to
constant monitoring of current covenant results through interim financial statements. In
addition, all financial projections and prospective budgets should include a section on how
loan covenants will be impacted.

Create a proactive system to monitor progress on all financial loan covenants. Recently, the
Department of the Treasury and the Federal Reserve required many banks to pass a stress
test to determine how the banks would perform under various circumstances. Create a stress-
test system for your company by varying your latest financial results. For example, reduce
revenues by 15%, increase your variable costs by 10%, then calculate how these changes
affect your financial covenants. The result will constitute your covenant risk profile. You will
gain a clear understanding of how certain events will affect the risk of a covenant breach.

Each interim financial statement and future projection should feature a covenant calculation
measured against the results required by the loan documents. Track this data over time and
adjust your covenant risk profile based on changes in your projections.

HOW TO DISCUSS COVENANT BREACHES

Possibly the most important aspect of the CPA’s involvement in covenant review is when and
how to communicate with a banker on covenant performance. The life or death of a company
can depend on how this step is handled.

What specific steps should you take in communicating with the banker on potential covenant
breaches? Given enough time, many potential covenant breaches can be absorbed by the
bank, allowing as much consideration as possible for a reasonable reaction. Waiting until the
last minute to disclose a breach is almost universally a bad idea.

When projections indicate that a financial covenant breach is possible, it is best to discuss the
situation with your banker. Bankers hate surprises. Tell the banker that your early projections
indicate a potential covenant problem and you want to discuss the possible effects. Although
this discussion is not hypothetical, it is based on projections. This way, the banker is
forewarned that a breach could occur, but he or she is not necessarily alarmed. The
conversation can have a more relaxed tone than one occurring at the last minute based on a
certain breach. The bank will monitor covenant progress more closely, and hopefully you can
prevent the breach from occurring.

If a breach does not occur, the banker will have gained greater insight into your business and
more faith that you will not be the source of last-minute surprises. If a breach does occur, the
bank will have had ample time to react appropriately.

WHAT TO EXPECT FROM A BREACH

Covenant breach penalties are almost completely within the control of the bank and can
range from a simple caution letter added to your file (after you request a breach waiver) to the
calling of all loans and the termination of a relationship. A covenant breach, no matter the
severity, is a technical violation of the loan agreement and allows the financial institution to
take any action legally available.

Midrange penalties could include a change in the interest rate paid or a onetime monetary
penalty. This step can be controlled to some extent by taking timely steps appropriate to the
circumstances.

Once a covenant breach is certain and the severity of the breach is clear, send a letter to your
banker outlining the circumstances and requesting a waiver or reduction of penalty. You
should have a reasonably clear idea of how the bank will react given your prior meetings on
the subject.

Be prepared to negotiate if the penalty is unreasonably severe. A comparison of how other

banks are reacting more favorably to the same circumstances could be useful. Diplomacy is a
key skill at this point. Once a covenant is breached, a great deal of the power shifts to the
discretion of the bank. Consider discussing how the severe penalty could impair the business
and increase the ultimate risk to the bank.

CONCLUSION
It is critical to stay ahead of the curve on all covenant issues in today’s tight credit
environment. Failure to do so can place your organization at a competitive disadvantage. Talk
to your bankers so you understand the forces driving their credit decisions.

View your banking relationships holistically and with an intention to engage in healthy,
profitable relationships. Negotiation is always possible if you take the time to gain useful
knowledge, create strong relationships, and engage in well-timed discussions on covenant
issues. Every negotiation is different, and it is not possible to provide advice to fit all
circumstances. Enter any bank negotiation cautiously and fully prepared with a well-
considered plan of action.

Why Banks Require Covenants

To effectively negotiate with a banker, you must understand how a financial
institution judges and mitigates risk. In general, your ability to negotiate will be a
reflection of the overarching relationship with your bank. It is very important to foster
a long-term positive and honest relationship with your banker.

Understand that your banker must deal with internal policies and external regulators
in defending any part of your loan package. Depending on the size of the loan, your
banker may be required to stand before a formal loan committee composed of credit
officers responsible for ensuring that the bank does not accept undue risk. The credit
committee will ask many in-depth questions, so providing your banker with as much
supporting information as possible (your business plan, financial projections, etc.) is
very beneficial. Your banker will be asked to justify to a skeptical committee why he
or she wishes to structure the covenants and interest rate in a particular fashion.

The committee will usually review the overall profitability of the relationship,
generally using a profitability model such as Risk Adjusted Return on Capital
(RAROC). Once the loan is approved, an external regulator could review the entire
package to determine if it agrees with the structure.

Common Covenants
In general, loan documents will contain both financial and restrictive covenants.
Knowledge of how these covenants are constructed and why they might be included is
very important in negotiating an effective loan agreement. When properly considered
and effectively applied, covenants can provide sound benchmark metrics that are
healthy for the organization. Poorly conceived covenants can devastate a business and
wreck its capital base. It is the CPA’s job to know the difference, negotiate effectively
and protect businesses from capital disruption.

Financial Covenants
Financial covenants are usually derived from common ratios and other metrics based
on the balance sheet (debt/equity), the income statement (operating profit, EBITDA),
and the statement of cash flows (operating cash flow). EBITDA can be used as an
approximation of positive cash flow.

Some covenants, such as debt service coverage ratios, reference several financial
statements. See the most common financial covenants in Exhibit 1 and run those
calculations through your most recent financial statements to determine which are the
most beneficial and detrimental to your interests.

Many businesses have unique characteristics, and it is important to review your

financial statements to determine if any presentation issue might alter the expected
covenant calculation. For example, a business that holds high-cost, long-lived rental
inventory might present that inventory as a depreciable asset rather than a current
asset. The debt acquired in the purchase of the depreciable rental inventory will be
presented as both long-term debt and the current portion of long-term debt. In this
case, a current ratio may be less favorable since the assets supporting the current debt
are not necessarily categorized as a current asset. At the least, some modification to
the current ratio calculation should be negotiated into the covenant.

Exhibit 1: Basic Financial Covenants

• Net worth
• Interest coverage ratio
• Liquidity and performance ratios
• Fixed charge coverage ratio
• Current ratio/working capital
• Debt ratio (leverage ratio)
• Debt service coverage ratio
Restrictive Covenants
A restrictive covenant requires a company to act or not act in a certain way unless
permission is expressly granted by the bank. For example, a bank may require a
company to carry key-man insurance on principle executives, maintain property
insurance or obtain permission before entering into a merger or acquisition.

Restrictive covenants tend to blend into the text of long loan documents, and you
should be careful to identify any circumstances or actions for which the bank expects
to grant permission. Poorly considered restrictive covenants can limit an
organization’s growth. A full discussion of the company’s business plan with the bank
and how restrictive covenants might negatively affect long term profitability should
be considered.