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Brian Beirl, DDS

Kingery & Crouse PA

TZDesign Group

What Lies Beneath: Understanding Debt Covenants and their Impact on your Company

By Mariem Talavera

Almost everyone agrees that more should be done to help businesses borrow.  But that mission is far from accomplished as the worldwide credit crisis continues to reduce the availability of capital.  Furthermore, shareholders of public companies are asking pointed questions about companies’ debt ratings, restrictive borrowing covenants, and potential lender renegotiations and lending institutions are requiring greater accountability from borrowers.  Considering these developments, it is more important than ever for management to assess compliance with their existing covenants or any risks of failing them.

What are debt covenants?

A covenant, in its simplest sense, is a solemn promise to engage in or refrain from a specified action, so debt covenants are financial or operational tests that you agree to meet during the loan term.  They are designed to provide the lender with assurance regarding your company’s ability to repay them.  Some examples of typical financial covenants are:

  • Maintenance of minimum working capital and debt service coverage ratios
  • Maintenance of minimum net worth
  • Restrictions on other borrowings, shareholder salaries, distributions, or dividends
  • Limits on borrowing bases

In addition, lenders usually establish other covenants, sometimes labeled “non financial” in the loan document, such as requirements to: 

  • Provide annual audits or reviews by a certified public accountant
  • Provide interim unaudited financial statements and other financial information
  • Maintain minimum levels of business insurance

Certain covenants can be very restrictive.  (e.g. lenders might restrict capital expenditures, thus curtailing the company’s ability to generate or increase revenues and cash flows).  For this and other reasons mentioned below, it is critical to understand the covenants the lender wishes to impose while negotiating the terms of the debt.

Understanding your debt covenant

First, make sure you compute the covenants as defined by the lender for current and future compliance.  These terms may sound self-explanatory, but the loan document has specific definitions.  For example, “net worth,” sometimes labeled “tangible net worth,” usually requires deducting intangible assets and receivables from shareholders, officers, and affiliates.

Similarly, debt service coverage ratio requirements can be based on a trailing period (for example, 3, 6 or 12 months), and can vary among lenders.  Also, debt service coverage, though usually based on EBITDA (earnings before interest, taxes, depreciation, and amortization) or EBIT, may include adjustments for non-cash charges, such as stock-based compensation.

Borrowing bases are usually limited to percentages of “eligible” receivables or inventory, meaning that the bank will not allow lending on certain receivables and inventories.  For example, eligible inventory generally excludes work in process and excess or obsolete inventories, which have minimal or no resale value.  Therefore, managing your receivables and inventories is critical to your borrowing ability.

What should you do?

Maintain a strong relationship with your lender This is critical in both good and bad financial times.  Keep in mind also that local banks may likely be more accommodating to the small business owner, so get to know your local bankers.

Understand and negotiate new or revised covenant.  Make sure you have a clear picture of your cash flow trends, both historical and projected.  Also, review your covenants with your attorney or CPA.

Periodically assess covenant compliance during the year.   Being proactive will put you in a better position when exploring your options and negotiating, and help you determine if you need to obtain a waiver from a lender.

What if you fail your covenants

If you anticipate violating any covenants, recognize this is generally not the time to ask for forgiveness in lieu of permission.  Lenders are facing increased regulatory scrutiny themselves, so having a plan to return your company to compliance and discussing such plans with your banker will put you in a better position when exploring your options and negotiating.  Make sure that any forbearance granted by your lender is in writing as any new creditor will be obligated to honor that forbearance should your lender sell your loan.  While any such situations are beyond the scope of this article, it is important that you consult with your key professionals if you find out your loan has been sold.

Failing your debt covenants technically represents an event of default.  Absent a waiver from your lending institution (which is not as easy to receive as one might expect), you could be required to reclassify your long-term debt to current on your financial statements, which could impair your working capital and cash flow and lead to a “going concern” opinion (which poses other issues, depending on your intended use of these financial statements).  An event of default also usually enables the lender to accelerate the maturity date and can be costly as loan documents generally allow lenders to increase interest rates during periods of default and assess fees for issuance of waivers.

And finally, never fail to govern yourselves, remembering that while you may rightfully believe your company could fail one or more covenants and still be capable of repaying the debt, this could be analogous to a driver refusing to yield his vehicle because he has the right of way. In either such case, you could be “dead right.”

Business to Business Advice Columnist 

About the Author
Mariem Talavera is an audit manager at Kingery & Crouse, P.A., Certified Public Accountants, located in Tampa, Florida.  Mariem has had experience in various industries, starting in cost accounting and progressing to financial accounting, operational analysis, and advancing to various controller positions for both large public and small private companies. Kingery & Crouse, P.A. is a full service public accounting firm with a staff of dedicated professionals providing audit (including SEC), tax and accounting services.  You may contact Kingery & Crouse at (813) 874-1280 or find us on the web www.tampacpa.com.