When companies are approved for a bank loan or line of credit, the loan agreement often contains certain affirmative and negative debt covenants. Debt covenants are conditions that the borrower must comply with in order to adhere to the terms of the loan agreement. Essentially, debt covenants bind a business to specific types of behavior while the loan or line of credit is outstanding. Most debt covenants require that year-end financial statements are prepared and submitted to the lending institution. Depending upon the amount of debt outstanding, the year-end financial statements may need to be compiled, reviewed or audited by a certified public accountant acceptable to the bank. Furthermore, some loan agreements will require monthly or quarterly internally prepared financial statements. Some other general types of debt covenants include financial covenants, management control and ownership covenants, and reporting and disclosures covenants. All debt covenants should be met to ensure that your business will be able to continue to service the bank loan or use the line of credit and also to help ensure a good relationship with the lending institution.
When companies are unable to meet their debt covenants, the lending institution may decide to do one of two things. They may call the loan, or they may issue a waiver. If the bank were to call the loan, the company would have one of two options. They would either need to pay the loan balance back to the lending institution, or the company would need to solicit other lenders to replace their current lending institution. Repaying the loan balance back may not be possible and soliciting other lenders is often very difficult to accomplish considering the company’s existing debt is in default. If a company was able to solicit other lenders, the interest rate would likely be higher. Furthermore, collateral and debt covenants would most likely be more restrictive than those the company was previously subject to as they would be considered higher risk. Also, additional guarantees may be required. If the company was able to obtain a waiver, then the company will typically just have to pay a fee to obtain that waiver from the lending institution. Obtaining a waiver would typically be the best option for a company in default as the company will be able to continue their business with the existing loan or line of credit. However, in the case of a line of credit, which has regular renewal periods, the lending institution may raise the interest rate on the next renewal due to the higher risk.
Bank loans or lines of credit can be very important to a business and, if not being taken seriously, defaulting on debt covenants can potentially ruin a business. Accordingly, management and individuals responsible for financial reporting should always be aware of the company’s debt covenants, so that the company does not default and put the company at risk.
By Ryan Wojdacz