What is a loan covenant?

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Business loan article

Loan covenant definition:

A condition that the borrower must comply in order to adhere to the terms in the loan agreement. If the borrower does not act in accordance with the covenants, the loan can be considered in default and the lender has the right to demand payment (usually in full).

Why do banks add covenants to the loan agreements

Banks usually add covenants in order to accomplish the following objectives:

1- Maintain loan quality
2- Control the loan and insure adequate cash flow
3- Preserve equity
4- In a borrower with a known weakness in its capital structure as a measure to improve this weakness
5- Keep an updated picture of the borrower’s financial performance and condition

Common loan covenants
Things that the borrower must do

Hazard Insurance / Content Insurance

The borrower is required to keep insurance coverage on the plant / equipment or inventory in order to safeguard against the catastrophic loss of collateral

Key-man life insurance

Insures the life of the indispensable owner or manager without whom the company could not continue. The lender usually gets an assignment of the policy.

Payment of taxes / fees / licenses

Borrower agrees to keep those expenses up to date as failure to pay would result on the assets of the company being encumbered by a lien from the government, which would take precedence to the one from the bank.

financial information on borrower and guarantor

Borrower agrees to submit financial statements for the continuing assessment by the bank. Financial statements are usually submitted yearly, while account receivable can be required every month.

Minimum financial ratios

The borrower is required to maintain a certain level in key financial ratios such as:

Minimum quick and current ratios (liquidity)
Minimum Return on Assets and Return on Equity (profitability)
Minimum equity, minimum working capital and maximum debt to worth (leverage)

Other loan covenants
Things that the borrower can not do

In addition, the borrower might be prevented from doing certain things via loan covenants.

No change of management or merger without prior approval.

Guarantees the continuing existence of your borrower and will impede the deterioration of financial condition due to merger with an unknown entity

No more loans without prior approval

Assures that the company does not take on excessive debt affecting the quality of the original loan.

No dividends/withdrawals or limited dividend withdrawals

In situations where the net worth is being eroded by the extraction of capital in the form of dividends or stockholder’s withdrawals. The lender might find it necessary to restrict the amount of money that can be taken out of the company. In subchapter-S corporations it is not uncommon to limit withdrawals to the owner’s tax liability.

Author: Commercial Loan Underwriter