Understanding loan covenants

Loans are built on trust and depend on loan covenants—pre-defined guidelines and progress updates—to maintain your lender’s confidence.

Covenants are the guardrails of a loan, providing both parties with a clear understanding of what’s expected from each other and a means for communication. Through a loan covenant, your company promises to stay financially sound, while your banker lays out expectations for financial measures that will guarantee repayment.

Before you take out a loan, learn the basics about covenants, and agree to terms you can follow.

Covenants protect your business.

Loan covenants are designed to ensure your company has the profitability and cash flow needed to repay your loan. Some covenants require you to take certain steps, while others prohibit specific actions. Covenants are designed to keep your business strong and to safeguard enough cash to cover the debt.

What kind of loan covenants are there?

Quantitative covenants set standards for financial measures that give your lender confidence in your company’s ability to repay a loan, like the strength of your business, cash flow, and debt level. Typical measures include debt to equity, cash to assets, and interest coverage ratios.

Qualitative covenants specify information that your company must provide, like quarterly financial statements or tax reports. These covenants also restrict actions your business can take, like assuming more debt or selling assets without your lender’s consent.

Communication makes covenants work.

Loan covenants are typically monitored quarterly to reduce the burden of oversight. Failure to comply with a covenant could result in penalties or risk your lender calling your loan in default.

Sometimes there are justifiable reasons to breach a loan covenant. Unexpected events may cause you to violate a covenant, like a sudden rise in material expenses while your business is recovering from a natural disaster. Rapid growth may cause your company to violate a cash to assets ratio loan covenant, especially if profits are used to buy inventory, hire workers, and extend credit to new customers.

Lenders are usually flexible in these situations, particularly if you show you are managing the situation well or are building a stronger business. Speak with your lender if you’re at risk of breaching a covenant. Ask for advice and keep your banker updated until you’re back in compliance.

Think of your loan covenants as an early warning system and clear statement of your lender’s expectations.  Structured properly and followed closely, loan covenants can help avoid payment problems and ensure a smooth and timely debt repayment.