Debt Covenant Concerns
April 13, 2012
By Mike Aversa, CPA
Now that we are closing the books and have issued external financial statements for December 2011, an item of concern has reared its head and we’d like to bring it to light: the number of companies who are or were not in compliance with their debt covenants.
A debt or loan covenant is an agreement you have with the bank regarding your loan. Boiled down, there are three variations of debt covenants:
- Affirmative covenants require that you do certain things like submit financial statements to the bank and/or carry liability insurance.
- Negative covenants preclude you from doing certain things, such as taking on additional debt or selling assets without your lender's approval.
- Financial covenants require that your company maintain certain liquidity or performance ratios. For example, your company may have to maintain a minimum net worth or generate a certain level of pre-tax profits.
It is important to know what obligations you have to fulfill so that you are not in violation. We have found a number of cases where clients seem to have been caught off guard by our findings. It is vital that you monitor the status of your company’s loan covenants, if not monthly, at least quarterly. Depending on the type of covenant, a violation can cause your bank to call its loan, halt any additional lending to you, exercise its right to seize any assets you posted as collateral, or initiate legal action to recover its money, to name just a few potential consequences.
If you know you are going to violate your loan covenant it is important to talk to your lender and your accountant as soon as possible. Waiting to do so can cause the bank to question your credibility. Additional costs can be charged by waivers from your bank and an extra invoice from your accountant for the extra work created by the covenant violation. Like anything else, dealing with it head on will garner the best result.