What Are Debt Covenants?
Debt covenants are certain restrictions or formal agreements between lenders and borrowers that are put on lending agreements to limit the borrower to operate within established rules. Debt covenants align the interests of both parties and offer benefits to both the borrower and the lender.
What Are The Benefits Of Debt Covenants?
For the lender, a debt covenant restricts the borrower from taking actions that could have adverse risks for the lender. As a borrower, a debt covenant will often reduce the cost of borrowing by securing lower interest rates on the amount borrowed.
Why Is It Important To Track Debt Covenants?
As a business owner, it is important to know the details of your debt covenants. A lot of times, if you have got somebody who is responsible for creating financial statements and handling the accounting for your business, business owners assume that debt covenants fall under that position. So the details of debt covenants are something that quite often gets overlooked.
It is easy to go out and qualify to borrow money, but a lot of people realize that once they get the money, all of the hoops they had to jump through, and all of the strings that are attached are detrimental to the business. We have seen a lot of companies that have run into significant issues just because of the type of debt that they take out. This is why it is important to have a strong understanding of what all is entailed with debt covenants.
Periodic Financial Statement Generation
1. What are Periodic Financial Statements?
Periodic Financial Statements are pretty self-explanatory. They are financial statements that are produced on a recurring basis. The exact period these financial statements are produced will depend on each company’s requirements. Periodic financial reporting may be generated monthly as a debt covenant requirement to prove the financial health of the company to lenders. Periodic financial statements may also not always be generated monthly, they may only be needed on a quarterly or yearly basis.
2. Clean-Up Requirements
Clean-up requirements are conditions in credit contracts. Clean-up requirements can mean a whole lot of things. If you have a covenant that requires an audit, then the bank or lender may require a clean-up requirement. Clean-up requirements are typically put in place to ensure that lenders do not rely too heavily on their line of credit and instead rely on revenue from sales as their primary income.
Borrowing Bases
1. What is a Borrowing Base?
A borrowing base is a limit on the amount that you can borrow from a bank. It is a metric used by financial institutions to determine the borrower’s assets and estimate the collateral to establish the size of credit that will be extended to the borrower. Typically borrowing bases are something that your financial professional is going to handle. A bank will require a borrowing base calculation on a monthly basis where you will fill in the requested information, supply supporting documentation, and send it to the bank. This is how the bank will determine what the limit is on the amount you can borrow from them.
2. How to Calculate Borrowing Base
The bank is going to give you the information on how the borrowing base is going to be calculated, and the borrowing base is going to be made up of a variety of things. It can be made up of a certain amount of accounts receivable. It can also be made up of certain amounts of inventory or inventory levels. Basically, what the bank is looking for is a measure of collateral. Usually, there are certain restrictions, such as lenders only accepting accounts receivable that are due within 90 days. Different lenders will have different requirements and calculations, so make sure that you are familiar with their requirements and expectations.
3. What is a Borrowing Base Certificate?
A borrowing base certificate is a document that is used to list all of a company’s available assets that can be used as collateral for a loan. The borrowing base certificate is the formal borrowing base calculation that determines the maximum amount of financing it can offer.
Other Debt Covenants
1. What Else Constitutes a Debt Covenant?
A wide variety of restrictions can be used as debt covenants. Examples of covenants include financial covenants that require borrowers to maintain a certain level of earnings, EBITDA, cash flow, debt to equity ratio, and more. They may also require informational covenants to provide periodic, audited financial statements.
2. What are the Advantages of Financial Covenants?
The advantages of financial covenants for borrowers include earning the lender’s trust by ensuring that there is security to the risk of the loan. There is also an advantage of ensuring financial stability for the borrower as they are required to maintain certain levels of cash flow or certain ratios.
2. What Does it Mean to Violate a Debt Covenant?
Violation of debt covenants can create tremendous issues for a company. Violating a debt covenant on a line of credit may even cause you to lose that line of credit altogether. If you do not lose the line of credit, you can have the limit on the line of credit reduced or pay penalties for not maintaining your covenants. Violating a debt covenant can be an extremely detrimental thing, so it is something that all business owners should need to be aware of, especially if you have loans for large amounts. You need to know what is collateralized, what the covenants are, and what you’re going to have to do to meet those debt covenants.
Conclusion
Debt covenants are very important for business owners to understand before approaching lenders. These are restrictions put in place by lenders to minimize the risk associated with the loan by restricting the actions borrowers can take. Debt covenants may require business owners to generate periodic financial statements to prove to lenders the financial health of a company. Lenders may also impose certain financial covenants that require borrowers to maintain a certain level of earnings, EBITDA, cash flow, etc.
If a borrower violates a debt covenant, that can create tremendous issues. Violating debt covenants may result in measurable costs to the company or something more severe like losing a line of credit. Debt covenants are not bad things. They do offer many benefits to both the borrower and the lender. They offer security for lenders as they minimize risks, and as a trade-off, the borrower often secures lower interest rates on the amount borrowed.
Contact our team today for more information on implementing debt covenant best practices.