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Covenants Explained: What They Mean and Why Your Bank Requires Them

Required financial covenant – the term often solicits groans from business owners, financial executives, and accountants alike when talking with commercial bankers about the structure of their debt facilities. While many borrowers have financial covenants, not every banker explains why they are implemented. At Univest Bank and Trust Co., our job is to help you manage your financing and treasury needs.  We also want you to understand the reasons behind how banks structure your loans.

Why have a financial covenant?

Financial covenants are not implemented to make doing business more difficult or as a “gotcha.” When a Bank and a client enter a loan arrangement there are certain expectations set for future performance. These expectations typically are based on past performance as well as what clients see for the next 12-18 months. Based on these expectations banks set covenants typically with some level of cushion or margin for error. Should the client breach a covenant, the breach serves the purpose of bringing all parties back to the table to discuss why the expectations of both parties were not reached. Often a breach in covenant may be caused by a one-time event or timing that is not indicative of actual performance. After discussion with your relationship team, a correct course of action can be taken. Often the Bank will walk away with a better understanding of the business when these situations arise.

Most Common Financial Covenants

Cash Flow Covenants – Debt Service Coverage or Fixed Charge Coverage Ratio

Cash flow covenants are one of the most common covenants that will be required for a business loan.

It measures the true cash flow from the company’s operations ability to pay its operating expenses, unfunded capital expenditures, and debt service. Operational cash flow eliminates non-cash expenses like depreciation and amortization. Debt service is the annualized interest expense and principal payment on outstanding indebtedness.

These covenants can be measured pre-or post-distributions or dividends. A bank usually likes to see a borrower’s ability to cover its debt service with operating cash flow by a minimum of 1.20x to 1.25x which provides the company some cushion. If a cash flow coverage ratio is below 1.0x, it suggests that the borrower is not generating sufficient cash flow to support its operations.  Ultimately the organization may experience working capital issues.

Leverage Covenants

Leverage is the measure of how much debt a borrower has and how the company is capitalized (debt versus equity). Common leverage covenants include:

  • debt-to-net worth ratio,
  • debt to tangible net worth ratio and
  • total funded debt to EBITDA ratio (also known as Cash Flow Leverage)

While debt is a great option to fund growth, too much debt might indicate trouble in the overall financial health of an organization and its ability to continue to pay its debt. Traditional banks will usually look at a maximum cash flow leverage ratio of no more than 3.0x or less deal and industry specific.  Balance sheet leverage thresholds may vary by industry.

Covenant Best Practices

It is important to keep an open line of communication with your banking relationship manager. The saying goes, “bankers do not like surprises.” If you and your management team identify something that could impact financial performance, reaching out to give your relationship manager a heads-up about the situation and how your team plans to adapt is a good practice. It shows you are on top of managing changes in the business environment and will not come as a surprise during your annual review or renewal time.

Additionally, share your financial covenant requirements with your accountant. He or she will be able to help you monitor and make financial planning decisions with the covenant in mind. Your accountant and banker are key members of your advisory team to help you successfully grow your business and manage business cycles.

Summary

In summary, your bank is part of your business advisory team. Covenants are a method to have a conversation to discuss changes and obstacles your company may experience during operations. With good communication, they should not be a source of anxiety and can also be a useful internal tool for management teams to monitor the financial health of their business.

If you have questions about covenants or would like a review of your company’s current debt structure, the commercial lending team at Univest Bank and Trust Co. is here to help educate and empower companies to grow their business and protect what is important.

Univest Bank and Trust Co. is Member FDIC, Equal Opportunity and SBA Preferred Lender.