A financial covenant restricts the amount of financial risk that the client can take on during the term of the loan. These are based on information contained in the borrower’s historic financial statements, projections, the borrower’s written and verbal representation, and the condition of the guarantors.
Determine the need for financial covenants based upon the size, term, and the borrower’s potential financial deterioration during that term. Loans that you do not anticipate the borrower to pay back during the term of the loan, (i.e. you expect to extend the loan upon maturity), generally require financial covenants, due to the potential risk. Smaller and short-term loans with a well-established source of repayment generally do not require covenants.
Financial covenants can be expressed in terms of dollar limitations, minimums, or in terms of ratios. Stating covenants in dollar amounts creates an agreement that is restrictive in structuring. Ratio covenants offer more flexibility, allowing the borrower to grow, as long as the covenants are maintained.
Examples of common categories of financial covenants are: Cash Flow Coverage Covenants, Profitability Covenants, Liquidity/Working Capital Covenants, Leverage Covenants, and Turnover Covenants.
Cash Flow Covenants
Perhaps one of the most used covenants is the Debt Service Coverage Ratio covenant. It is defined as net operating income (NOI) divided by annual debt payments. This measures the borrower’s ability to generate cash from operations in order to cover debt obligations. It also measures what is left over after all operating and debt obligations are met. Minimums on this can be set at the loan policy thresholds or can be increased if there are other risk factors present that must be mitigated.
This ratio is used a lot with rental property. The property should produce adequate income to pay all the operational expenses, satisfy debt obligations, and still have some funds left over.
One issue here is what to do with capital expenditures when the borrower elects to treat as an expense on the income statement, as opposed to treating as the addition of an asset and capitalized. I often see this issue with hotels, where the owner elects to aggressively expense one-time capital improvements. This could abnormally reduce the numerator of net operating income, thus making the company appear in a worse position than it actually is. A possible solution is to have the business owner identify all the capital expenditures made in a year that were expensed. These can be added back to NOI to create a more accurate picture of the operating performance. I would also suggest that a capital expense allowance be deducted from NOI to allocate for an average amount of capital expenditures that would be spent in an average year.
Another issue is that the DSCR does not take into account any equity draws that are paid to the owner, since these come out after the NOI calculation. Here, if it is necessary for the owner of the entity to take money from the company in order to live, it may be proper to treat this as a salary expense; this comes out prior to NOI. Another option would be to place a leverage covenant that limits the amount of money the owner can withdraw from the company.
Interest Coverage measures a company’s earnings before interest, taxes, depreciation, and amortization (EBIDTA) to interest expense. Another method is to compare EBIT to interest expense. In each case, there is no consideration given to the principal portion of the loan payments.
The Fixed Charge Coverage measures either EBIT or EBIDTA compared to interest, principal, and lease obligations. This covenant may be applicable when the borrower has substantial rental or lease payments each year, in addition to loan payments.
Utilizing cash flow covenants is a good way to gauge if your borrower is generating sufficient cash from obligations to satisfy all loan and lease obligations. It also answers the question of how much is left over for regular and unexpected repairs, and also payments that will be made to the owners.