The Skinny on Loan Covenants

Covenants, by definition, are promises made by two parties to each other.  Banks use covenants to communicate what's important to them in a banking/lending relationship.  Most business owners go along with the covenants because they want the loan.  At times, the mutual promises made seem to get lost in the transaction.

Most covenants seem to cover issues pertaining to ownership/management and to financial performance.  Given the current economy, more attention is paid to the latter.  Financial covenants can be a line of credit payout for 30 days.  You and the bank promise each other that the line of credit wasn't a permanent investment in the company.  The ability to pay the bank out for at least 30 days is proof of that promise.  Covenants can also be used to measure leverage ( a debt to worth covenant) ie total debt divided by total equity.  This covenant protects the bank and the business from excessive leverage.  A cash flow covenant (cash flow divided by current maturities of long term debt) shows both parties that the company has adequate cash flow to cover loan payments with a cushion, typically 25-30%.

Given the current economy, banks are placing more emphasis on loan covenants due to their capital constraints and loan quality issues.  Your line of credit may be coming up for renewal or your mortgage loan may be maturing.  It would be a good idea to know what loan covenants exist in your loan commitment and did you meet them.  Since loan covenants are promises made by both parties to each other, you would expect any broken promises could trigger discussions between you and your bank.  Be prepared!