Understanding the Purpose of a Loan's Financial Covenants

“I haven’t missed a single payment.”  That is a sentence I have heard from almost every struggling borrower I have represented.  The client has been placed in “workout” at its bank, and doesn’t understand what caused the move from a traditional relationship manager to a more hardened workout officer.  Sure, the company has had a rough few quarters, or even a year or two of losses, but it has made every loan payment that came due.

The problem is, the aforementioned client has violated some or all of its loan’s financial covenants.  While these covenants may seem arbitrary and unimportant to a borrower, banks, and federal banking regulators, take them very seriously.

When people think of loans, they tend to think of something akin to their mortgage.  A person goes through an approval process, procures a loan, uses the money and pays the lender back over a period of time with little or no interaction between borrower and lender after the initial loan.  The bank does not ask for a W-2, or credit card bills each year to verify one can still afford his or her house.  As long as payments are made, the relationship moves forward unimpeded.

This is drastically different than a business loan, which requires reporting to the lender, financial reviews, audits and more.  Below, I compare and contrast a personal mortgage with a business loan to outline why the additional scrutiny is in place and why a lender makes decisions based on financial covenants.

First, let’s look at the lender’s perspective when a mortgage is in payment default.  A person buys a house for $360,000 and borrows $300,000 from the bank.  The borrower makes payments for three years, before payments stop.  Assuming that by this time, the loan has been paid down to $285,000 and the property has appreciated to $370,000, the bank can sell the house for a steep discount and still make all its money back.  In addition, the lender has relationships already established with firms that can find a buyer relatively quickly.  Even if the bank has to sell the house for 60% of its value, the resulting loss would only be $63,000.  The current mortgage crisis notwithstanding, these are very low-risk loans for a lending institution to make.

Now, let’s look at a $5,000,000 loan made to a general contracting company.  At the time of the loan, the construction company was netting $3,000,000 annually, but has since fallen on tough times.  The company burns through all of its cash and finally misses a payment to the bank, at which time the bank becomes aware of the financial distress plaguing the company and the company’s decision to cease operations.  A quick glance at the lender’s collateral in this scenario:

  • Accounts Receivable: Since the construction company cannot finish its current projects, the existing customers refuse to pay the past-due amounts.  Customers with finished projects hold payment in hopes of being able to pay pennies on the dollar, claiming warranty and other issues
  • Inventory: What little inventory the company has is left over from specific projects and has very little value.
  • Fixed Assets: Most vehicles were leased, and other equipment is minimal because the company is providing general contracting work, which requires very little machinery.  Office equipment holds little to no value.
  • Property: Offices were leased.

The value of this company was in its relationships, brand in the market and expertise in the employees.  The relationships and expertise leave with the employees, and the brand is tarnished by the rumors of financial distress.  In this scenario, the bank could be looking at losing the entire $5,000,000.  What little collateral the bank holds may be more than canceled out by the cost to procure and liquidate that collateral.

In the same construction scenario above, but with covenants in place, the bank may have learned that the construction company was in financial distress long before the doors had to be closed.  If a lender and company have a year to prepare, solutions such as refinancing, reorganization or selling the company are still viable.  A scenario in which there is no cash to pay vendors or lenders takes most, if not all, options off the table for both the lender and the borrower.  Understand also, that this is not just a lender problem.  In most cases, ownership has provided personal guarantees, putting their own personal assets at risk if the bank loan is not repaid.

The above construction company example is the exact reason why lenders require financial covenants in their loans.  The risk of losing money on these deals is significantly higher, and the lender wants as much warning as possible to find a resolution.  Financial covenants are a loan’s smoke alarm, warning lenders and borrowers of when the company’s financial performance is declining to dangerous levels.  In the eyes of a lender, breaking a financial covenant is the same as missing a loan payment, because it indicates that without change, future payments will be missed.

Contact us if you have questions regarding financial convenants in a business loan and visit the Schneider Downs Meridian webpage to view all services that we can offer to companies that need management consulting, corporate restructing or debt financing.

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Material discussed is meant for informational purposes only, and it is not to be construed as investment, tax, or legal advice. Please note that individual situations can vary. Therefore, this information should be relied upon when coordinated with individual professional advice.

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