Managing debt covenants
Have you ever found yourself in a situation where debt covenants put your business in a precarious situation? It is one thing to secure a loan, but it is another thing to maintain one especially when it has debt covenants. In this post, we’ll look at the implications of debt covenants through the lens of our fictional entrepreneur Lewis.
Lewis is a persona we introduced in part 1 of this series when he was learning about how to incorporate his business. He now owns a well-established construction company with several loans, including a general operations loan. The loans have helped the Company expand and take advantage of new opportunities, but they also have compliance obligations called covenants. Lewis’s strengthens lie in his skills managing operations, but his business advisor has recently asked for a meeting to discuss the Company’s loan covenants. This is important because one of the covenants requires the Company to submit quarterly reports to the bank. Lewis lets his business advisor take care of the reports, but with the next report coming up his advisor has flagged some things to address.
At the meeting, Lewis’s advisor spends a few minutes refreshing him on debt covenants. A debt covenant is a restriction or obligation a lender places on the loan to decrease the risk of a loan default. Debt covenants make the loans safer and more beneficial to both parties. Covenants grant the lender more control over how the funds are used by prohibiting or obligating specific actions. Lewis asks the following question: “What do you mean restrictions and obligations? How many types of debt covenants are there?"
There are three types of debt covenants:
A positive covenant refers to an action the Company agrees to take. This action can range anywhere from asking the company to hire local people, sending them quarterly financial statements, or performing regular maintenance on equipment.
A negative covenant is the opposite of a positive covenant. In this case, the lender is stating the borrower cannot take an action. By signing the loan agreement, the borrower agrees that they will not take certain actions as long as the loan is in effect. A negative covenant will restrict a business owners' ability to perform specific actions. For example, a lender may ask the borrower to not issue dividends for the duration of the loan to ensure the loan is being used for its designated purpose.
A financial covenant relates to the financial performance of the business. Generally, financial covenants are numerical limits placed on ratios calculated from the financial statements during a specified period or at a specific point in time. Whereas the two covenants above restrain or obligate a business owner directly, a financial covenant, although indirectly similar, will allow the business owner to decide on the best actions to take concerning the Company’s financial performance. For example, the financial covenant may be placed on the working capital ratio, where the company agrees that its working capital ratio will not fall below 1.5. For some companies, a working capital ratio of 1.5 gives a lender comfort that the borrower will be able to pay back the loan.
Now that Lewis knows about the different types of debt covenants let’s look at his covenants.
Lewis has agreed to maintain a debt service coverage ratio of 1.45 or higher. The debt service coverage ratio measures a business's cash flow available to make debt payments. There are different ways to calculate the debt service coverage ratio, but often it is calculated by dividing EBITDA (Earnings before interest, taxes, depreciation, and amortization) by the total debt service payments (interest payments + loan payments) in a period. The bank requested the Company send the quarterly calculation of this ratio to monitor the Company’s ability to pay back the loan. For more information on the debt service coverage ratio, you can check out BDC’s page about it.
Lewis has a second financial covenant, the working capital ratio which divides short-term assets (cash, accounts receivables, etc.) by short-term liabilities (accounts payable, payroll liabilities, etc.). It is a good indicator of whether the Company has the resources available to maintain operations on a short-term basis. This one also measures the ability to pay liabilities as they come due. Lewis agrees to maintain a working capital ratio of 1.5.
Lewis has been asked to provide the lender with quarterly financial statements and the financial covenant ratio calculations. This allows the lender to monitor the financial performance of the Company on an ongoing basis. This enables the lender to update their risk assessment regularly. This also allows Lewis to connect with his lender each quarter to build their relationship. Why don’t you want to break your covenants?
Lewis’s advisor has reviewed the Company’s most recent performance and is worried that the Company may be offside with its covenants by the end of the quarter. If the Company breaks one of its financial covenants the lender could call the loan. The Company’s loan is long-term, so if it is recalled the whole Company’s future could be in jeopardy. Lewis’s advisor notes that the Company has several long-term contracts that have been delayed and explains that the Company’s short-term liabilities are roughly the same, but the Company’s revenues are down. The decrease in revenue, without a similar decrease in costs, has decreased both EBITDA and accounts receivables compared to the prior quarter.
The end of the quarter is about a month away, so Lewis has about that much time to remedy the problem before the quarterly reports show a covenant breach. Lewis and his advisor identify how much additional revenue is needed to meet the covenants and they map out a plan to achieve their targets over the next month. Rather than try to push through the log-jam with the delayed long-term projects, Lewis decides to reallocate a portion of staff to subcontract for a friendly competitor over the next month. With the slowing of the long-term projects and the demand for skilled labour, the Company is able to keep its staff fully employed and generate short-term revenue. Lewis’s advisor cautions him that this is not a long-term solution, but a measure to make sure they are onside with the bank, while also keeping their high-skilled workers fully employed.
While Lewis is optimistic that the covenants will be fine by quarter-end, his advisor suggests he may want to have a conversation with his lender about the Company’s recent financial performance. It is valuable to have a great relationship with your lender through open communication, such as keeping them aware of any challenges you are experiencing. “If you have this honesty and trust established between your lender and yourself, then you may be more likely to solve the offending issue, and they could waive the violation without imposing any harsh reparations.” – Ian Varley from eagle business credit."
Going forward, Lewis’s business advisor has two recommendations for him to stay onside of his debt covenants. This time Lewis had the capacity, relationships and resources to remedy the problem, but that might not be the case in the future.
To keep up to date on the company’s financial performance, Lewis will be switching his accounting operations from a desktop-based accounting system to a cloud-based accounting system. It's the right choice for his business because cloud-based accounting can do so many things for Lewis’s business.
Check out what Ryan Lazanis, a pioneer of cloud accounting in Canada, had to say about cloud accounting and its implications for small and medium-sized businesses.
Some types of purchases can improve financial covenants, while other purchases can create the appearance that the Company’s performance is worse than it is. Spending money on advertising right before the end of the quarter will lower the Company’s working capital ratio and EBIDTA. On the other hand, making project expenditures on long-term projects can increase the Company’s revenue and receivables depending on the financial accounting rules. Being strategic about the timing of purchases will be important for Lewis until the long-term projects are back on track.
There is certainly a benefit to having debt, but when covenants are involved, they can also be a lot more work. The good thing is that this additional work can help both the lender and the lendee identify adverse trends in financial performance before they become big problems. The additional compliance work creates an opportunity to analyze a Company’s financial performance more closely, motivating management to think through financial decisions in more detail. Having covenants means that there is a lot at stake, but they can be a good thing when you know how to manage them effectively
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