How can loan providers make sure they are safeguarded when they extend credit to borrowers? Equally important is the question of how borrowers can make sure their expectations of the lender are very clear. To put it simply, loan covenants. Bank loan covenants, for example, are crucial for both the lender and the borrower because they outline the terms under which the loan is made. Although some types and examples of loan covenants may appear straightforward at first glance, a thorough understanding of their operation and the various outcomes of a covenant breach is essential. Everything you need to know about loan covenants will be discussed in this article.
What Are Loan Covenants?
Loan covenants are a collection of separate agreements between the borrower (the debtor) and the lender (the creditor). The terms of a loan typically include a list of prohibited and required actions for the borrower to take. A credit agreement or loan contract is a legally binding document that specifies the terms of a loan between a debtor and a creditor. Loan amounts, interest rates, repayment schedules, and (often) a laundry list of them are some of the specific loan terms you may discover in a credit agreement.
Furthermore, the purpose of loan covenants is to ensure that your firm can generate the necessary revenue to repay the loan. Borrowers agree to certain conditions, known as covenants.
Types of Loan Covenants
There are basically three types of loan covenants: those that are good, those that are bad, and those that are financial. Here are a few more details about each.
#1. Positive or Affirmative Loan Covenants
Affirmative loan covenants (also known as positive loan covenants) serve as reminders to borrowers that they need to take action in certain ways to protect the financial stability of their businesses. The need to pay all taxes relating to the business or employment, carry sufficient insurance, and keep good financial records are all examples of the kinds of covenants that lenders look for in a loan applicant. Examples of positive loan covenants.
- Keep up-to-date financial records and submit them on a periodic basis to the bank.
- Necessary in order to keep the company in good standing with the jurisdiction where it was first founded.
- All applicable business and employee taxes must be paid.
#2. Financial Loan Covenants
When evaluating a company’s compliance with financial loan covenants, lenders look at how closely actual results compare to the borrower’s estimates made by the chief financial officer (CFO), owner, or management. Furthermore, a lender will be more satisfied if the business is making progress toward these goals. Current ratios and borrowing base calculations (which establish the maximum amount that a company can borrow) are two common types of financial loan covenants. Here are some examples of financial loan covenants.
- Recent proportion (current assets divided by current liabilities)
- The “borrowing base,” or the value of an individual’s accessible collateral, is a key indicator of that person’s access to credit.
#3. Negative bank loan covenants
Negative loan covenants can be found in most loan agreements. They are useful for setting up barriers regarding ownership or finances. However, restrictions on the company’s ability to incur new debt, constraints on the number of dividends that can be paid to shareholders, a prohibition on the company engaging in any mergers or acquisitions without the lender’s consent, and so on are all instances of negative loan covenants. Here are some examples.
- Keeping assets from changing hands without the bank’s approval.
- Restricting the company’s and/or its shareholders exposure to debt.
- Putting limits on or banning limits paid to shareholders.
Typical Categories of Covenants
- Liquidity: Cash, marketable securities, receivables, and inventory all contribute to a company’s liquidity. Common ratios used to monitor compliance with such covenants include the current ratio and the inventory turnover ratio.
- Leverage: According to the amount of cash generated each year vs the total amount of debt. Lenders will only provide a certain amount of leverage if the borrower can demonstrate stable cash flow, solid growth prospects, or adequate secondary collateral.
- Net worth: Assets minus debts is a common financial ratio. Minimum net worth and maximum debt-to-asset ratio are two common types of covenants.
- Cash Flow: The company’s ability to meet its debt obligations is evaluated in terms of these covenants. EBITDA is the standard method for calculating cash flow.
Why Are Loan Covenants Used?
The purpose of loan covenants is to prevent this. Loan covenants have two basic types and examples of functions, and they do it by clearly mandating or restricting specified actions or circumstances. The first is to lessen the likelihood of negative outcomes, and the second is to balance the scales in favor of the lender.
When a Loan Covenant Is Breached, What Often Occurs?
A loan covenant breach occurs when the borrower does not abide by the terms of the loan agreement. The lender may grant a waiver to cover the problem, depending on the seriousness of the infraction. More severe infractions, however, may result in the lender suspending the loan, seizing collateral, demanding prepayment, or taking legal action. In addition, lenders may impose steep penalty fees for loan covenant violations to recoup any losses.
In order for a covenant in a bank loan to be effective, there must be open lines of communication between the borrower and the lender. Furthermore, in the event of a loan covenant breach, maintaining open lines of communication with the lender will help both parties come to an understanding of what went wrong and how to prevent it from happening again.
Bank Loan Covenants
Bank loan covenants are requirements that place limits on new debt beyond current borrowings, changes in business strategies or senior management, and various financial compliance requirements on borrowers. However, these loan covenants are frequently assessed using standard ratio types and examples in areas like liquidity, leverage, activity, and profitability. The usual metrics, which tell the lender about the borrower’s viability, have been presumed to be appropriate in all studies on bank loan covenants.
What Is the Benefit of Bank Loan Covenants?
The objective of bank loan covenants is twofold: to protect the bank from default risk and to assist the borrower in staying out of trouble if they default on their loan. They can say what the borrower must and must not do (a positive debt covenant). Therefore, a business should consider these requirements when it makes strategies to stay in line with its loan agreement.
Are Covenants on Bank Loans Negotiable?
The answer is yes! When a bank or lender makes a loan offer to a borrower and outlines the proposed terms in a Letter of Interest, the bank, and the business owner have room to negotiate the loan covenants.
Although a lender’s Letter of Interest or credit facility proposal is not legally enforceable, it is an excellent starting point for an entrepreneur to learn about the loan covenants that the lender plans to impose. Before accepting a loan from a lender, it is in the best interest of a business to fully comprehend it. Also, see HOW DO BUSINESS LOANS WORK
What Are Examples of Financial Covenants?
- Controlling the ratio of debt to equity
- Achieving and sustaining a target level of operating costs
- Maintaining a certain level of cash flow
- keeping an agreed-upon interest coverage ratio
Which of the Following Is a Loan Covenant?
A loan covenant is a pledge that outlines the circumstances under which a loan will be made between a borrower and a lender. The borrower will make the commitment to maintain strong financial standing during the loan’s term as part of a loan covenant.
What Does “Covenant” Mean?
A covenant is a promise in a formal debt arrangement to take or avoid certain acts or fulfill certain standards. Covenants in finance typically refer to clauses in a financial contract, like a loan instrument or bond issue, that set the maximum amount that the borrower can borrow in the future. Lenders frequently impose covenants to safeguard themselves against borrowers’ defaulting on their obligations.
What Are the Types of Covenants?
- Negative Convenants
- Affirmaive Convenants
- Financial Convenants
#1. Negative Convenants
“Negative covenants” urge borrowers to avoid activities that could affect their loan repayment ability. Furthermore, borrowers must often keep certain financial ratios at certain levels as of the financial statement date in order to comply with the most frequent type of negative covenants.
#2. Affirmaive Convenants
A loan agreement may contain an affirmative covenant that stipulates the borrower must fulfill certain conditions. Lenders may have conditions attached to their loans, such as requiring borrowers to follow certain legal guidelines or provide annual audited financial statements. A breach of an affirmative covenant may result in a total default.
#3. Financial Convenants
Financial covenants are monetary-related assurances or pacts made by the borrower. EBITDA-based leverage and interest cover ratio are the two financial covenants found in the majority of debt term sheets.
Conclusion
Loan covenants provide lenders and investors with a way to ensure that the risk attached to a loan does not increase over time, prior to maturity. Depending on how they are incorporated into the loan’s terms, covenants may or may not be able to achieve this effect. However, Investors should be aware of whether a loan has maintenance covenants, which are often present in directly-originated and structured loans, or incurrence covenants, which are more frequently linked to bonds or covenant-lite loans.
Loan Covenants FAQs
What does a loan covenant require?
A loan covenant (promise) outlines a borrower’s and lender’s loan policies. Bank use covenants in loan agreements to protect their position and increase the possibility of complete loan repayment.
Can a covenant be broken?
Covenants are unenforceable if they expire, a history of violations exists, or no one benefits from them. You could risk legal action if you ignore them.
How long do covenants last?
After 20 years, it is typically difficult to enforce a breach of covenant. The Limitation Act of 1980 stipulates that land claims must be filed within twelve years. However, time begins to run at the occurrence of the breach, not the date of the deed.
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