It these tough economic times, it is much more common for not-for-profit organizations to have a violation of their loan covenant. When a loan covenant is not met (for example, a requirement to maintain a maximum debt to tangible net worth ratio), the consequences can be very negative to the entity’s financial statements. Remember that violating a covenant means that the lender can legally “call” the debt, or demand repayment in full. Because of this, accounting guidance requires that the debt be classified on the Statement of Financial Position as 100% current liabilities. This can throw your current ratio way out of whack, showing your financial position as much weaker. Potential donors or grantors may think twice about giving your organization any funding. In fact, there could be questions about the organization’s ability to continue operations for the next year. What if the bank calls the debt next month? Can the organization still survive?
Loan covenants frequently include specific minimum or maximum ratios that must be maintained. You may have a loan agreement that requires certain ratios be calculated on a quarterly basis, while another ratio may only be required to be calculated annually.
If an organization obtains a waiver from the lender for a particular loan covenant violation, they may be able to show the debt as long term, in accordance with the payment terms of the agreement. However, if there are quarterly ratios that have to be met, even a bank waiver as of year-end may not be sufficient to not show the debt as all current. Here’s an example. Suppose your year-end is June 30 and you did not maintain a required ratio as of that measurement date. You are able to obtain a waiver of that particular violation from your bank. The audit is about to be issued in mid- September, and it is very probable that you will also not meet a particular quarterly ratio as of September 30. In this case, the debt would still need to be classified as current because the bank could still call the loan within the next year.
So future quarterly required ratios for the next year need to be looked at. What are the chances these ratios will be met? If it is not probable, the debt should be classified as current.
It’s a vicious circle….decreased funding can cause a loan covenant violation… a loan covenant violation results in a weaker financial position…a weaker financial position can result in further decreased funding. One solution may be to request your bank to modify the loan agreement to adjust required ratios that the organization can realistically meet.
For more information on debt and loan covenants, check out our article on how covenants can affect the balance sheet
By Colette Kamps, CPA