What is a Loan Covenant?
A loan covenant (a promise) is an agreement stipulating the terms and conditions of loan policies between a borrower and a lender. Banks include covenants in loan agreements to preserve their position and improve the likelihood a loan will be paid by the borrower in full accordance with the loan’s terms and conditions.
Loan covenants are designed to protect the earning assets of the borrower, ensuring your business can generate the revenue necessary to repay the loan. Covenants are stipulations that you, as the borrower, agree to.
Covenants make sure that (1) the lenders’ rights are secure, (2) there is a reliable mechanism to rectify the process, and (3) there is a clear illustration of events leading to the borrower’s default.
Three Major Loan Covenants
Affirmative Loan Covenants “I Will” Affirmative loan covenants remind the borrowers that they should perform expressed activities to maintain a healthy operation of their businesses, which will in return create a stable financial performance.
Examples of Affirmative Loan Covenants:
- Required to pay all business and employment related taxes.
- Required to maintain current financial records and deliver to bank at regular intervals.
- Required to maintain insurance policies for business and possibly include lender as “additional insured”.
- Required to for the business to maintain a good standing in the state where it is formed.
Negative Loan Covenants “I Will Not” Sometimes, the lenders may want to create a boundary around major financial and ownership decisions made by the borrower. Banks include negative loan covenants that require the business owner to seek the bank’s permission to take certain actions.
Examples of Negative Loan Covenants:
- Limiting the total indebtedness for the business and/or shareholders.
- Restricting or forbidding restrictions paid to shareholders.
- Preventing a merger or acquisition without the Bank’s permission.
- Preventing the sale of assets without the Bank’s permission.
- Maintaining a specific Debt Service Coverage Ratio.
Financial Loan Covenants provide measures over whether the borrower is reaching or closely attaining the targets of the estimates provided to the lender. Therefore, to be on the safe side, lenders may provide restrictions on the amount of credit the borrower may access at a given period.
Examples of Financial Loan Covenants:
- Current ratio (current assets divided by current liabilities)
- Borrowing Base Calculation – the metric determined by the value of assets you have available to pledge as collateral for a loan
Lending and borrowing are based on trust, but clear, mutual expectations of any relationship are essential. When your business needs to borrow, you need to trust your lender and understand how your lender ensures that you will repay your loan.
Communication makes covenants work.
Violating a loan covenant may result in the borrower being penalized or the lender calling the borrower’s loan into default.
Keep in close contact with your lender if you think a covenant may be breached. This communication allows for both parties to come together to plan a course of action for the borrower to return to financial soundness.
Contact the Commercial Banking Team at Mars Bank with any questions: 724-625-1555 x250.