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With any bank loan, make sure the collateral matches line of credit and that you choose the right interest rate with your accountant.

EBITDA And Other Scary Words: Scary Words No.11 - Debt, Collateral, Covenants, Guarantees and More

If you ever read (and I mean read, not just signed) a bank loan or revolving credit agreement, then you know the document can be a little overwhelming.

Whenever first 20 pages of a document include mostly definitions, you know it is going to be a tough read. You must always refer to what the words mean throughout the document. But, every other word sends you to a different section for further clarification.

Of course, you should understand key words and phrases. You should challenge them if necessary. Treat this like any other business transaction—you want the best possible result with the least possible pain.

So let’s go through some important items we think you should understand. Find out which questions you need to ask when dealing with your bank.

Collateral

Collateral is the asset(s) you are pledging as security against repayment of the loan. You forfeit these pledged assets in the event of a loan default. Depending on the size of the loan or revolving credit, you want to make sure that the collateral matches or exceeds your loan or line of credit.

If the lender determines your line of credit based upon 80% of allowable trade receivables, then your only collateral may be your trade receivables. If the collateral includes all the company’s assets, then you may want to renegotiate the terms and see if you can reduce your exposure in case you default on your loan.

Early Termination Date

Read this section carefully.

When I provide a service, the quicker I get paid, the better. However, in many loan agreements, if you pay off your loan before the due date, the bank can hit you with a termination or prepayment fee. This is because the banks wants to keep you from switching to a competitor when interest rates drop—or if you find better terms.

Remove the early termination fees (if possible) from the agreement. If you cannot remove them entirely, then at least reduce the amount of time in which they apply.

Guarantor/Guaranty

The guarantor is the individual or entity that guarantees payment or performance of the whole or any part of the obligation (there may be multiple guarantors). Banks typically require this. However, depending upon the financial strength of your company, you may be able to negotiate this out of the agreement.

You might think to yourself: “I have a loan that is limited to 80% of my allowable receivables, but I gave as collateral all the assets of the company and I must guarantee the loan as well. This doesn’t seem exactly fair.”

These are examples of why you must better understand what your loan agreement does for you and what it requires from you.

Interest Rate

 The annual interest is typically a variable rate based on either LIBOR (London Interbank Offered Rate) or the prime rate. We’ve seen historically low-interest rates for the past eight years; however, they have slowly been increasing. Ten years ago, the prime rate was close to 8%. Choosing a higher fixed rate or a lower variable rate that can change is something to go over with your accountant.

Affirmative and Negative Covenants

 An affirmative covenant is any promise the company must fulfill. Some example of affirmative covenants are:

  • properly insuring the assets of the company;
  • making sure the bank is aware of any violations of the law, statute, regulation or ordinance of any governmental body or agency of any governmental body; and
  • stating when the bank receives the financial statements, which a certified public accountant may compile, review or audit.

A negative covenant prevents the company from certain activities such as

  • entering into any merger or consolidation,
  • selling certain assets,
  • entering into any other agreement wherein the company becomes liable for other obligations or
  • making loans to related parties.

The lending institution may stipulate certain ratios which the company must reach that fall in the affirmative or negative covenant section. (Your accountant and lawyer should review each covenant to make sure you can comply with and/or meet them.) You may be able to negotiate your loan to remove or amend some of these covenants so that you are not in default at the onset.

So, What Happens if You Break a Covenant?

 You could default on your loan. The bank could issue a waiver, charge you with a fee or ask you to pay off the loan. “Charging a fee” seems to be a reoccurring theme in bank loans.”

When you are in need of bank financing, always check with your accountant and lawyer before entering into such an agreement. They may offer advice to alleviate burdens that lending institutions may try to include in the agreement—saving you time and money in the long run.

"This article originally appeared on Financial Poise and is reprinted here with permission."


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Yesenia Cardona is a Private Business Services Group Senior Manager experienced with reviewed and compiled financial statements, outsourced finance and accounting, and tax planning and preparation for businesses and individuals.

Charles J. Saydek is Senior Manager in the firm’s Private Business Services Group and specializes in tax services and retirement plan audits. ed Public Accountants.

Mr. Ryan specializes in audits, reviews, compilations, tax services, and business consulting. He serves clients in a variety of industries, including construction, real estate, manufacturing and distribution.