Understanding the Ins and Outs of Debt Covenants

This time of the year we find many business owners and financial managers asking us questions about debt covenants, specifically, “what are they” and “what is our lender looking for from us?”

What Are Debt Covenants?

A debt covenant, in general, is a requirement imposed by the lender designed to impose certain conditions on the business for the benefit of the lender. It’s a means to secure the borrower’s performance in a manner it considers sufficient. This ensures that repayment will not be jeopardized. Typically, the covenants are set forth in specific terms within the borrowing agreement for a promissory note, lease, line-of-credit or similar facility. The lender will usually specify that a CPA firm, such as Dannible & McKee, is required to certify the borrower’s financial statements as being fairly stated in accordance with accounting principles generally accepted in the United States, by way of either an audit or review engagement.

What Is Our Lender Really Looking for From Us?

A lender is really looking to determine your ability to repay the borrowing as scheduled. Additionally, for red flags that indicate characteristics in your business, structurally and/or financially, that might put repayment at risk. A lender often controls these risks by imposing debt covenants.

Not all borrowing agreements include the same covenant requirements. Depending on the lender’s faith in the borrower’s ability to repay, there may be none at all. When they are present, some common examples include:

Affirmative Covenants – items that the borrower agrees they will always do. Examples may include:

• Submitting financial statements audited or reviewed by a CPA within 120 days of year end.
• Submitting internal financial statements on a monthly basis.
• Submitting the owner’s tax returns annually.
• Provisions for maintenance of corporate and organizational existence, payment of taxes, maintenance of insurance, environmental covenants, etc.

Negative Covenants – items that the borrower agrees they will not do. Examples may include:

• Prohibition, among other things, of guarantees, sales of assets, mergers, redemptions, dividends and distributions, loans to insiders and affiliates, etc.
• Making payments to owners outside of agreed-upon terms or subordination agreements, which are often drawn up at the same time as the borrowing, where significant related party debt or borrowings from shareholders exist.
• Prohibition of the incurrence of additional indebtedness with other lenders or leasing companies (these are all examples of situations which could impact the borrower’s ability to pay back the lender’s debt).

Financial Covenants – detailed financial statement ratios and custom calculations developed from the financial statement captions which are used by the lender as performance targets.  The objective is to assess the borrower’s ongoing capacity to fund its minimum debt service requirements. They may also assess liquidity, amount of working capital available, or any other financial guidepost that the lender feels relevant to keep tabs on the lender’s ability to repay the borrowing. Examples may include:

• Debt Service Coverage Ratio – an indicator of the ability of the borrower to meet its obligations to pay based upon an evaluation of net income adjusted to the cash basis.
• Debt to Net Worth – an indicator of how heavy the borrower’s debt load from lenders is in comparison to capital contributed by the owner himself. This highlights potential warning signs.
• Current Ratio – a comparison of the assets of the borrower that can be accessed within a year to the obligations that must be satisfied within the same time frame: a general measure of liquidity.

Since these performance calculations always are derived from financial statement captions, you can see why it is so important to a lender that an independent CPA certify the financial statements before covenant performance is evaluated.

If you fail to meet a covenant, the lender may consider this a condition of default, and may, at its option, accelerate and demand the balance of the full outstanding debt balance to be paid immediately.  The lender may also impose a fine and/or penalty, require you to accept a forbearance agreement and many times propose increased interest rates in exchange for forbearance from accelerating the debt.

As a practical matter, if you generally have a long-standing relationship with your lender, they will often seek to find a way to work these things out.  The lender will often agree to one-year waiver of non-compliance upon request following explanation of the reasons for and circumstances of the default.

The big BUT of course, is that the institution is not required to waive covenant default. They will expect that you demonstrate an understanding of what caused the non-compliance and require you have a plan to ensure it doesn’t happen again–which is only fair, as it’s their money on the line.

Overall, if you are concerned that you may not fully understand your debt covenants, or whether you might be in non-compliance with your lender, contact Dannible & McKee.  We can review your borrowing agreements and the terms and conditions in them with you to allow you assess any potential issues. We can then suggest any appropriate communication that might best be furnished to your lender to keep things on the right track.

To learn more about Debt Covenants, contact Brian W. Johnson, CPA, CFE, CCIFP, audit partner at (315) 472-9127 or via E-mail.