If you have borrowed money from a Bank for working capital or to purchase a property then you may not necessarily have come across Banking Covenants. However if you are planning to borrow to acquire another business or finance a significant expansion, then depending on the amount borrowed, your lender may seek to introduce covenants into your facility agreements.
So what is a Banking Covenant?
The Dictionary definition of a covenant is a formal agreement or promise between two or more parties. A Banking Covenant quite simply is an agreement that you make with the lender to abide by certain financial and operational measures until your debt is repaid.
Three main types
There are 3 main types of Banking Covenant:
Most facility agreements will include covenants that relate to the production of timely financial information. For example, you may be required to submit your annual financial statements within a set period after your year end. Some lenders will want to see more regular financial information, perhaps quarterly or even monthly. Commonly referred to as Management Accounts, these will include, as a minimum, a Profit & Loss but sometimes also your latest Balance Sheet and a Cash Flow Statement. For the larger transactions a borrower might also be required to submit their annual financial budget each year so that the Bank can monitor actual performance against forecast.
This category contains covenants that are designed to protect the Bank from any unexpected calls on cash or diminution of assets. Restrictions may therefore be placed on the level of capital expenditure that can be undertaken or the amount of the owners’ remuneration in a given period. Limits are set and the lender’s prior permission then required to exceed those limits. The borrower might also have to covenant not to sell or dispose of part or all of the business without the lenders consent or to not pledge assets to other lenders, raise additional debt, or make loans to third parties.
The lender is focused here on the ability of the business to continue to service debt. Financial covenants are designed to monitor key credit metrics or benchmarks. They provide the lender with early warning of any significant divergence from the financial forecasts, against which the lender agreed to support the business. As with all the other categories the selection of Financial Covenants tends to be deal specific but will typically include measures that relate the operating profit or cash generated by the business against the amount required to service debt by way of a ratio such as 1.5:1 or 1.35:1. The lender should set these covenant tests at a level which provides sufficient headroom to allow for normal fluctuations in performance. If set too tightly then there might be a risk of a Covenant Breach. This could have consequences which, at best, might be an uncomfortable conversation with your financial stakeholders. However depending on the trading record to date it might also lead to the imposition of a fee in exchange for an agreement by the lender to grant a temporary waiver and then more intensive monitoring of your numbers until back on track. Very occasionally, and depending on the severity of the covenant breach, the lender may seek to re-negotiate the terms of the facility.
Banking Covenants provide the lender with powerful controls on its lending. It is important that the borrower understands the detail of the facility agreement and specifically the scope and implications of any covenants. This paper is only designed to provide a very quick overview of what is a complex subject and if you require more information it is recommended that you approach your existing advisers or alternatively a specialist in corporate and commercial credit.