When you take out a business loan, you should expect the final agreement to include covenants. Loan covenants are requirements and/or restrictions that lenders impose to limit their risk.
Dos and Don’ts
There are different types of covenants. So-called affirmative covenants are things your lender requires you to do, such as providing regular financial statements, carrying certain insurance policies, making timely employment-tax payments, etc. Negative (restrictive) covenants prevent you from doing certain things without the lender’s approval, such as borrowing from other sources, making management changes, selling equipment, etc.
Show Them the Money
Financial covenants require your company to maintain certain financial ratios related to working capital, net worth, debt, profitability, and cash flow. For example, a lender might require that a company maintain a specified debt service coverage ratio or debt-to-equity ratio for the life of the loan. These ratios are calculated using figures from your financial statements.
If your cash needs are unpredictable, you may decide to establish a line of credit instead of taking out a loan. Line of credit lenders frequently limit risk by establishing a borrowing formula based on a certain percentage of current accounts receivable. If your agreement includes a condition like this, be sure to keep a close eye on accounts receivable aging and be proactive about collecting past due accounts.
Noncompliance Could Be Costly
Be proactive about protecting your interests when you are negotiating a loan. Carefully review the loan agreement to identify all covenants and requirements. Make sure you fully understand them and have considered the possible repercussions before you sign. If you violate a covenant, your loan is technically in default and your lender may choose to call the loan, take the collateral, or substantially modify the terms of your agreement.