If you’re like most business owners, when you take out a loan for your business, you look at the interest rate, the personal guarantee, and the funding amount, but you probably skim over the fine print with the debt covenants. In fact, many business borrowers aren’t even familiar with this phrase. What does it mean? Well, to put it simply, debt covenants are conditions related to the loan. In other words, they’re promises you make to the lender.
The Purpose of Debt Covenants
Debt covenants are designed to protect the lender. They outline certain activities that you should and shouldn’t do as a borrower, and when you follow these conditions, you are more likely to be able to repay your loan. But indirectly, these rules also benefit you as the borrower. Debt covenants help to reduce defaulted loans, and as a result, they allow lenders to offer lower interest rates and higher funding amounts to all their clients.
Positive vs. Negative Debt Covenants
Debt covenants fall into two major categories: negative and positive. Negative covenants refer to things you can’t do during the lifetime of the loan, while positive covenants refer to things you must do. To give you an example, here are a few common negative debt covenants:
- You can’t incur additional debt.
- You can’t sell certain assets.
- You can’t pay out cash dividends.
- You can’t enter into new lease agreements.
- You can’t merge with another company.
In contrast, here are a few examples of positive debt covenants or things you must do while you have a loan:
- You must subordinate all new debt to this loan.
- Your business must meet certain financial ratios such as debt-to-worth ratios, liquidity ratios, or debt-to-cash flow ratios.
- You must keep your business’ building or other facilities in good condition.
- You must stay current on your tax obligations.
- You must maintain life insurance policies for select employees or coverage for certain assets.
- You must create financial statements using a certain accounting method.
These are some of the most common debt covenants you’re likely to see on a loan, but they certainly aren’t the only ones.
Testing Debt Covenants
Your lender may require some proof that you’re following the covenants. That often includes giving the lender financial statements at regular intervals. For instance, if your loan’s covenants say you can’t increase the salary of certain employees or shouldn’t pay cash dividends until the loan is paid off, your financial statements assure your lender that you’re making good on those promises. In some cases, the lender may require financial statements prepared by an objective third party who can verify the statements are unbiased and honest
If your business accidentally or deliberating breaks one of the covenants on a loan, the lender can issue a notice of default. At that point, the lender can demand full repayment or take over actions such as putting a penalty interest rate into effect or lowering the limit on your line of credit.
To protect yourself and your business, you may want to ask about debt covenants before you take out a loan. If you don’t have an internal accounting professional, you may want to hire someone to look over the covenants. Then, to ensure you stay compliant, you may want to get help preparing financial statements for your lenders. If you take out numerous loans, it’s important to borrow wisely and make sure the debt covenants don’t contradict each other. You don’t want to get stuck in a position where maintaining one covenant causes you to break another one. That said, keep in mind that debt covenants are generally pretty straightforward, and as long as you understand the rules on your loan, they’re usually pretty easy to follow.