Loan covenants that are based upon profitability of the company can be based upon a net profit or operating profit margin, a percentage of sales, or a minimum dollar amount. Baselines for these ratios can come from RMA or Moody’s averages of companies in the same SIC or NAICS codes for appropriate minimums on the company.
The first profitability covenant is the Net Profit Margin. This covenant measures the borrower’s ability to earn income on each dollar of sales. It can be measured before or after taxes. Again, industry averages or breaks in the industry quartiles may be applicable to use. Historic results are an indication of what to expect in the future, unless there are major changes in the company.
Gross Margin Covenant measures how profitable sales are, considering only the cost of production or services. A gross margin covenant is preferable to a net profit margin covenant where the primary credit concern involves the efficiency of the borrower in converting revenues to cash before looking at interest, depreciation, or selling, general and administrative (SG&A) expenses.
In my time as a lender, I have never seen the above ratios used as loan covenants. What I have seen in loan covenants, is a minimum dollar amount of net profit required by a company. I have also only seen that used once. As with any covenant, the profitability covenants are possible tools to use, but it is not required that each loan would have this type of monitoring placed upon it.
On a multi-year loan, you may want to require an increase in the net profit or the profit margin over time. This can be based upon the borrower’s expectation that their profitability will increase during this period, as a result of new capital expenditures placed in a business or other changes in the firm.
Liquidity or Working Capital Covenants are quite useful in measuring the borrower’s liquidity and equity position. Use these covenants to determine if the borrower has sufficient working capital to operate comfortably when compared to industry averages or to the borrower’s historical needs.
The timing of judging these covenants is crucial. A company’s liquidity can change dramatically during the course of an operating cycle due to seasonal fluctuations and normal expansions, or contractions of receivable and inventory accounts. So, when this is measured, it can be a crucial factor to either a passing or failing covenant test. The timing can also give a false sense of hope or concern to the company’s true financial picture.
The Minimum Working Capital Covenant measures either a dollar amount or a minimum working capital ratio. It requires an understanding of the borrower’s cash flow cycle. Since each company has a unique working capital situation, industry averages can be used to determine appropriate minimums.
A Current Ratio Covenant requires the relationship between current assets and current liabilities to be greater than a set ratio. A ratio threshold of 1.25:1 means that there must be $1.25 of current assets for every $1.00 in current liabilities. Industry averages and historic company figures can be used to determine what is appropriate.
The Liquid Asset Test Covenant requires a borrower to maintain a minimum dollar amount of cash and marketable securities. This can be placed upon the borrower, or I have also seen this as a combination between the borrower and guarantors. This covenant is applicable when the borrower must maintain a liquid reserve to either meet a forthcoming obligation, such as a large debt payment for capital expenditures, or to cover a likely or anticipated temporary downturn in cash flow. It would be appropriate to not only see this information on the financial statements for the company, but to also provide liquidity verifications in the form of copies of the actual bank or brokerage statements. This covenant is also useful where there may be some weaknesses in other ratios like the DSCR. A liquidity verification will show additional money that is available to provide coverage of debt and expenses in case of a downturn.