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Loan Covenants
Loan agreements between banks and their business borrowing customers generally
contain covenants which require that the borrower do certain things
("affirmative convenants") and not do others ("negative covenants") during the
term of the loan agreement.
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Maintain adequate insurance.
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Furnish financial statements quarterly and annually.
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Do not merge with or acquire another company.
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Do not allow other liens on company assets.
Examples of tailor-made covenants are:
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Maintain a current ratio of not less than 1.5 to 1.
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Maintain tangible net worth in excess of $500,000.
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Maintain a ratio of total liabilities to tangible net worth of no greater than
3 to 1.
Covenant requirements by be extensive depending upon the amount and term of the
loan and the credit standing of the borrower.
Most banks will monitor compliance with the loan covenants on a quarterly basis
with the receipt of quarterly and annual financial statements. Sometimes the
bank will require a periodic certification by a corporate officer or
independent accountant that no covenant violation has occurred (Compliance
Certificate).
How Banks Deal With Covenant Violations
Banks take loan covenants quite seriously, and generally are careful to
watch for violations, although sometimes such violating may go undetected. Once
detected, however, the bank may...
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Waive the provisions of the violated covenant for a certain period of time.
This waiver period generally lasts for up to one year at which time the
covenant would be in full force and effect again; or Amend the covenant so that
the borrower will not be in continuing violation.
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Demand a cure of the violation within a certain period of time. The cure period
is specified in the loan agreement between the borrower and the bank, and
generally runs from 10 to 30 days. Sometimes, however, no cure period is
permitted with respect to certain covenants.
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If the violation has not been cured by compliance, waiver or amendment, or if
no cure period is permitted, the bank may declare that an event of default has
occurred and demand payment of the loan.
Bank loan covenants should not interfere with a company's normal operations if
drafted properly. It is incumbent upon the bank and its borrower to come to
mutually agreeable covenant that each can live with for the length of the loan
agreement.
Before And After You Agree To Loan Covenants
The bank and the borrower must take time to agree on a set of covenants
that will be appropriate for the term of the loan. Here are some tips that may
be helpful before and after you sign your loan agreement:
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Read and understand all the proposed covenants carefully before agreeing to
abide by them.
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Be certain that financial covenants, those that test for specific ratios or
absolute numbers, are not so restrictive as to hinder your normal operations.
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Prepare forecasts (best and worst cases) to determine if compliance can be
assured. Allow for seasonal fluctuations that may cause temporary violations
(e.g. leverage may be higher during certain times of the year because of high
inventories and consequent higher payables or line of credit borrowings).
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Review your covenants when financial statements are prepared to determine if
any violations may have occurred.
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When contemplating major actions, such as a large capital expenditure or an
acquisition, make sure that no covenants will be violated because of those
actions.
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Keep your banker advised as to covenant violations, potential or actual, and
try to work out remedies. This cooperative attitude tells your banker that you
are as concerned about the violations as they are.
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