Understanding and Monitoring Loan Covenants

Manufacturing is a capital-intensive business that often requires financing to support operations. Financing arrangements for significant loans typically are supported by complex agreements that include numerous terms, most notably, loan covenants that establish ongoing requirements that the borrower must adhere to over the term of the loan.

Loan covenants are a cornerstone of commercial lending, designed to protect lenders by ensuring borrowers maintain certain financial and operational standards. Yet, when these covenants are violated, especially without proper identification and communication, the risk to all parties escalates significantly.

The Importance of Proactive Monitoring

Loan covenant violations inherently increase risk. However, the severity of that risk often depends on how the violation is handled. Minor, one-time breaches that are identified early, communicated transparently and accompanied by a corrective action plan, may pose minimal additional risk. In contrast, when a financial institution discovers a violation only after receiving financial statements, without prior disclosure from the client or their CPA, the situation becomes far more concerning.

In many cases, the failure to identify and communicate a violation may represent a greater risk than the violation itself. This underscores the critical role of CPAs and financial managers in monitoring compliance and maintaining open lines of communication with lenders.

Accounting Implications Under GAAP

From an accounting perspective, GAAP (Generally Accepted Accounting Principles) requires that debt callable due to covenant violations be classified as a current liability unless specific conditions are met, such as:

• • The creditor has waived the right to demand repayment for more than a year from the balance sheet date;
  • The creditor has lost the right to demand repayment for more than a year; or
  • The debtor is likely to cure the violation within a grace period, preventing the debt from becoming callable.

For covenants measured quarterly or at other interim periods, waivers may also be necessary for anticipated violations within the next twelve months.

Financial Reporting Covenants

Most loan agreements include covenants related to providing financial information. These typically specify:

• • The accounting basis, usually GAAP;
  • The level of assurance, such as audited, reviewed or compiled; and
  • Deadlines for year-end and interim financial statements.

Unreasonable deadlines can render covenants ineffective as they are frequently violated. Moreover, lending institutions should carefully consider the scope of interim reporting requirements. Overly broad demands may lead to technical violations. A more flexible approach, such as requesting specific information as needed, can help avoid unnecessary breaches.

Restrictive vs. Protective Covenants

Loan agreements often contain both restrictive and protective covenants:

• • Restrictive covenants limit actions, such as dividend distributions, owner compensation and capital expenditures; and
  • Protective covenants require maintaining minimum working capital, adequate insurance coverage and regular financial reporting.

Collateral maintenance is particularly critical. For example, lines of credit often tie borrowing limits to a percentage of accounts receivable and inventory. Falling short of these thresholds can trigger immediate consequences.

Understanding Numeric Covenants

Numeric covenants tied to operating results, like the debt service coverage ratio or times interest earned, may reflect temporary downturns. These metrics often reset annually or follow a rolling four-quarter basis, allowing for recovery over time.

Balance sheet-related covenants, such as the current ratio, working capital levels, debt-to-equity ratio and tangible net worth, measure a company’s financial position at a specific point. Unlike operating metrics, these do not reset, and any shortfall must be corrected to regain compliance.

Planning for Loan Covenant Compliance

Manufacturing companies will often prepare annual budgets and ongoing forecasts for operating results. In addition, year-end decisions might be made for tax planning purposes and to reward employees with bonuses and other incentives.

As part of their planning process, manufacturers should also monitor how decisions will impact numeric loan covenants. This will allow them to ensure compliance with covenants, or, in some situations, provide the opportunity for advanced communications with financial institutions when violations are expected. This can be especially helpful when the business has had a strong year but discretionary expenses at year-end could lead to violations.

Conclusion

Loan covenants are standard in nearly all significant financing agreements. With proper monitoring, these covenants can both protect the interests of financial institutions, while also enabling manufacturers to operate effectively and maintain a strong financial position that will allow for continued financing under favorable terms.

Contributing author: Victor W. Vaccaro, Jr., CPA/ABV, CFF, is an audit partner with over 35 years of experience providing auditing, accounting and consulting services. He specializes in serving the manufacturing industry and focuses on consulting engagements that enhance client profitability. For more information, contact Vic at vvaccaro@dmcpas.com or any of our professionals at (315) 472-9127.