Covenants in Business Loan Agreements
From a certain amount, the banks include in their loan agreements a certain number of commitments to be paid by the borrowing company. The latter will have an interest in becoming aware of these commitments and accept only those it believes to be able to respect in view of its financial forecast.
The different natures of engagement
The covenants, or clauses of safeguard, group together the clauses inserted in the loan agreements intended to guarantee the rights of the lender and to prevent the unpaid ones. They define different commitments to the borrower, to do, not to do or to ask for prior authorization, we distinguish:
1. The clauses requiring the borrower to provide its financial statements to enable the bank to follow its evolution, the obligation to inform it of any change in the bylaws;
2. The clauses that aim to ensure that repayment capacity is used primarily to repay the loan subject of the contract :
- Limitation to make investments and subscribe to subsequent loans. The borrower must then request prior authorization from the bank to carry them out;
- The prohibition on the company to act as guarantor for the benefit of third parties (guarantees guaranteed on first demand, …);
- The obligation imposed on shareholders to maintain a current account level of partners (blocking agreement).
- Limitation of the amount of dividends (amount or% of net income) over the repayment period of the loan;
- Excess cash flow clause. When the results are higher than those predicted in the business plan, part of these results is allocated to accelerated repayment of the loan. In case of transfer of fixed assets, a portion of the proceeds of the resale is used to repay the loan, …. ;
- Clauses allowing the company to repay faster than expected on its own initiative.
The commitments defined above are not restrictive, the bank will provide the ones that seem most appropriate to each situation.
3. The borrower’s commitments to meet a number of ratios.
The consequences of a “breach of covenant”
Failure to comply with one of the standards set on these ratios (breach of covenant) allows the bank to request the lapse of the term (immediate payment of all future loan maturities). However, it will rarely implement this sword of Damocles, aware that it might accelerate the default of the borrower.
If the loan agreement so provides, a higher rate margin (+1 to + 1.5%) or additional commission will be applied.
A breach of covenant will allow the bank to ask the borrower certain questions, or even to obtain from the manager commitments to restore his financial position, for example, encourage him to a transfer of assets or activity to generate cash flow, to restructure its activity.
Given the consequences of non-compliance with covenants, the borrower must, therefore, make sure to commit to ratios that he believes he can respect over the term of the loan, as indicated by his financial forecast, in a low assumption. profitability.
All the commitments listed above obviously hinder the freedom of action of the borrowing company. Like all other parameters of the loan contract, these commitments are negotiated, the best companies managing to be exempted.
The accounting treatment of covenant breach
Non-compliance with a ratio has consequences in terms of presentation of accounts. The non-compliance with a covenant noted on the financial statements at the end of the year potentially leading to the forfeiture of the term is the entire debt that must be reclassified at the end of financial debt to CT. Only a letter from the bank issued before the closing date by which it renounces the forfeiture of the term allows reclassifying the debt.