Do You Know Your Loan Covenants? Lenders Do, and They’re Looking Closely
The financial industry is slowly crawling its way out of the meltdown it experienced during the last few years; however, covenant defaults are on the rise. Lenders are looking closely at borrowers’ financial statements and are exercising the remedies contained in the loan documents when financial statements don’t comply with the loan covenants. These remedies impose severe conditions on borrowers and are referred to as covenant violations. It is important that you understand what your loan covenants may be and the possible impact of a failure to comply with your financial covenants.
Most loan documents contain covenants about ratios – how your business assets and liabilities relate to each other. The most common ratios are the Debt Service Coverage Ratio and Fixed Charge Coverage Ratio. These ratios may be calculated differently for the approval process versus when the loan is finalized and written. Another ratio used is Tangible Net Worth requirements.
• Debt Service Coverage Ratio: shows the amount of cash flow available to meet annual interest and principal payments on debt, including sinking fund payments.
• Fixed Charge Coverage Ratio: indicates a firm’s ability to satisfy fixed financing expenses, such as interest and leases.
Taking the ratios a step further, some loan documents contain further covenants regarding a business’s liquidity. There is no specific liquidity formula; however, liquidity is often calculated by using liquidity ratios.
• The degree to which an asset or security can be bought or sold in the market without affecting the asset’s price. Liquidity is characterized by a high level of trading activity. Assets that can be easily bought or sold are known as liquid assets.
• The ability to convert an asset to cash quickly. Also known as “marketability.”
Liquidity Ratio (a.k.a. Current Ratio)
The current ratio is a liquidity ratio which measures a company’s ability to pay short-term obligations. It is also known as “liquidity ratio,” “cash asset ratio” and “cash ratio”.
The Current Ratio formula is:
The ratio is mainly used to give an idea of the company’s ability to pay back its short-term liabilities (debt and payables) with its short-term assets (cash, inventory, receivables). The higher the current ratio, the more capable the company is of paying its obligations. A ratio under 1 suggests that the company would be unable to pay off its obligations if they came due at that point. While this shows the company is not in good financial health, it does not necessarily mean that it will go bankrupt – as there are many ways to access financing – but it is definitely not a good sign.
The current ratio can give a sense of the efficiency of a company’s operating cycle or its ability to turn its product into cash. Companies that have trouble getting paid on their receivables or have long inventory turnover can run into liquidity problems because they are unable to alleviate their obligations. Because business operations differ in each industry, it is always more useful to compare companies within the same industry.
When a bank finds that a business has violated its loan covenants, it can impose potentially severe remedies against the borrower. The bank can call the debt, resulting in a new financing institution, receivership, forbearance, or bankruptcy. The lender could also allow the borrower to keep the loan but provide waiver in the form of fees to waive covenants and waivers to re-write loan documents under new terms. Other remedies taken include loan amount reductions, loan acceleration with demands for immediate full payment, and non-renewal of the loan.
Even if your business pays your obligations as agreed and outlined in your loan documents, you could still be in violation of one or more of these covenants. The financial industry is slowly recovering; however, they are beginning to more closely scrutinize all areas of their business and this scrutiny often falls on loan covenants. If you would like assistance to ensure that your financial statements are in compliance with your loan covenants, our experts at Apple Growth Partners can help.