Loan covenants

What it means

Covenants are the conditions a bank writes into the loan agreement beyond the repayment schedule. They split into financial ones, measured by ratios taken from the accounts, and non-financial ones that require or forbid something.

A typical financial covenant tests net debt against EBITDA, or equity against total assets. The formula in the contract is usually its own and does not match the accounting definition, so it is calculated from the contract, not the statement.

Covenants are not security. A lien or a guarantee protects the bank once the company has stopped paying; covenants are meant to warn it earlier, while there is still room to negotiate. The bank therefore learns of a breach from the accounts, often months before a single instalment would be late.

How it works in practice

Non-financial covenants often bite harder than the ratios: no further borrowing, no guarantees for other companies, limits on distributions, turnover to run through the bank’s account, and notice of a change of owner.

The bank tests the ratios on agreed dates from the reports it receives, and the borrower has to report a breach itself. The bank may then call the loan, raise the margin or demand security; the talk turns to a waiver or to refinancing, where the creditworthiness of the company is assessed again.

For clients with a loan we copy the covenants from the agreement into the monthly report and calculate them by the contractual formula on current figures. The managing director sees how close the threshold is before the annual financial statements and decides on an investment or a profit distribution knowing its effect.

What to watch out for

A distribution of profit or a loan to the owner just before year end cuts equity and flips the ratio. A covenant breached at the reporting date also moves the long-term loan into current liabilities, which sinks the liquidity ratio and the covenants resting on it.

Loan agreements often contain cross-default: a missed covenant or a late payment on one loan or lease counts as a breach of the others too. One overlooked ratio on a small overdraft can thus open the way to calling the entire investment loan.