Leverage covenants are some of the most critical covenants in properly structuring a term credit agreement. They warn the lender when debts or liabilities of a company are disproportionate with the company’s equity base. One of the frequent reasons a lender charges off a loan is because the borrower has incurred excessive debt. When debt is too high, there are fewer cushions to fall back on during a downturn. These covenants are mandated in some government-backed lending programs, such as Rural Development.
The leverage covenant can be especially useful when used in conjunction with Debt Service Coverage Monitoring, in making sure the company can (1) satisfy its debt obligations, and (2) in making sure the owners are not draining out too much equity from the company. But the nature of the covenants and the quality of financial statements that a lender will see may raise some problems.
The first is, what items are really equity, and what is truly debt on the balance sheet of the company? It is not often clear with a cursory review of the statements. The first place to look is on the asset side. What items are truly assets? I would suggest that receivables from related parties or owners should be discounted from the asset base, and at the same time, the corresponding entry would be to reduce this company’s equity. (The equation assets = liabilities + equity must remain in balance.) Another place to look is intangible assets. Do they really provide value? What about obsolete assets like inventory? These may be discounted as well.
The next place to look is on the liability side. If there are debts owed to company owners and the lender has subordination agreements in place that place the debt junior to the lender’s, these may be treated as a subordinated equity. Intercompany liabilities should also be looked at. Next, equity should be inspected. Are there any equity classes that have a superior claim to the company assets than what the lender does? If so, these should be treated as debt. These adjustments to the financial statement should give a truer version of the debt and equity position of the company. Note that if there are any qualifiers that will be placed on how the debt and equity is calculated, these should be defined in the covenants.
If the company’s current leverage is high relative to industry averages or higher than the lender’s preference, you can structure the leverage covenant to require the leverage decrease over time in order to decrease the risk during future periods.
Total Liabilities to (Tangible) Net Worth limits the ratios of total liabilities to net worth or tangible net worth. This limits the overall leverage of the company. A possible problem is using this test with a company that has large fluctuations of payables or operating lines of credit. These swings can have a negative impact on the ratio. A liability to net worth ratio of 4:1 is required by Rural Development backed financing.
Total Borrowed Money Debt to (Tangible) Net Worth focuses only on debt obligations and not on other types of liabilities. If your primary objective is to control the amount of debt a borrower can incur and you want to apply a fairly tight test, a borrowed debt to net worth ratio is more effective than a liabilities to net worth ratio.
Total Debt Limitations is a covenant with an absolute hard number and does not fluctuate. In order to deal with leverage issues, while allowing the borrower to avoid incurring considerable debt, you should establish an absolute dollar limit on the amount of debt the company can have outstanding.
Contingent Liability Limitations limits a borrower’s ability to incur contingent types of liability. The lender can limit liability by including, in the definition of liabilities, all guarantees and other contingent liabilities. Normally, you should set an absolute limit on contingent liabilities by stating “none are permitted” or that “only guarantee A and B are permitted but no others.”
Generally, these leverage covenants can be effective tools to cause the borrower to maintain certain amounts of equity in the company and/or to make sure company debt does not grow beyond the capability of the company to manage it.