Those Pesky Loan Covenants

With the struggling economy and your potential customers as scarce as water in the desert, your sales may have suffered last year. If your sales suffered, then your profits probably did also. If you profits suffered, then your net worth may have decreased due to losses incurred. If your net worth decreased, then either your assets decreased or your liabilities increased (or a little of both). None of these scenarios are healthy for your business.

They are also not healthy for your floorplan provider, the bank that furnishes your line of credit and/or your mortgage lender. If you did not have a good year, your lender’s collateral has probably decreased and their risk has likely increased. When risk increases, banks become nervous.

Most bank loan agreements have loan covenants that customers (you) must stay compliant with. Your business likely met these loan covenants when the loan was originally issued. Sometime after that, your business changed enough to make you non-compliant with these terms.

If your lender requires you, as part of the loan terms, to furnish GAAP (Generally Accepted Accounting Principles) financial statements on a monthly basis, you need to ensure your controller is aware of the need to prepare the financial statements in the required format to satisfy your finance company.

Your lender may also require you to furnish certified financial statements (audited, reviewed or compiled) from an approved CPA firm. If so, you must go through the process and expense of having your CPA firm perform additional procedures while they are gathering information to complete your tax return. Then they can prepare the proper disclosures and formatted financial statements to comply with your loan covenants.

Covenants are to protect the interest of the finance company. They have probably been “burned” over time by different businesses that violated their loan agreements and left them trying to collect on loan. If your lenders don’t eventually get repaid, they will not have money to loan to you or anyone else in the future.

Some common loan terms are:

• Furnishing the lender with monthly financial statements prepared according to GAAP

• Providing year-end certified financial statements from your CPA

• Meeting debt-to-equity ratios

• Maintaining certain working capital and net worth amounts, distributions and/or owners’ salaries not exceeding a percentage of net income

• Keeping a certain amount of cash invested in an account at the bank

• Agreeing to pay interest and any principal required by the appropriate due date(s)

• Meeting a required minimum EBITA (earnings before interest, taxes and amortization/depreciation)

All of these covenants have a purpose. They protect the lender and establish required guidelines to protect its investor’s funds that were loaned to you. Most business owners attempt to accomplish the same thing with the capital they have invested in their business and/or loans given to their company. You eventually want to get your investment and/or loans returned to you along with some return on that investment/loan. Most people want to earn money on their capital and also manage the risk they are assuming.

What happens when you violate one or more of your covenants? Your lender eventually finds out and comes to talk to you about it. The lender normally wants to know what caused the violation to happen and what you can do to correct it and reduce their risk.

What can you do about it? First, and especially now, you should be monitoring any loan covenants you have on a monthly basis, so hopefully, you can anticipate a problem before it happens. This should give you enough time to rectify the situation and/or plan how to correct it before your lender uncovers it. If you find you can’t meet your covenants by correcting the problem, you will need to plan how you are going to meet the covenants by changing your business plan, investing more funds in the business, reducing expenses, increasing sales, reducing distributions, signing personal guarantees, etc.

When your lender calls to inform you that you have broken one or more of your loan covenants, then you’ll be ready with an answer and a plan to hopefully put them at ease. They will want to know the time frame in which you will accomplish this. They may want a budget and/or a projection showing them how you will get to your goal of becoming compliant with the loan terms.

If you are in violation, the lender may decide to rewrite the loan covenants you are required to follow, they may issue you a “waiver” for the specific time period or, in the worst-case scenario, call in the loan and ask for it to be repaid. They will normally give you what is called a “go away letter” directing you to find another lender to pay them off. If this happens, especially in today’s economy, it could be devastating to you and your business.

In the worst-case scenario, the lender knows you can’t rectify the problem and violations. Then they come in and take over your business and/or “repo” your assets they used as collateral. This is not the position you want to be in. In most cases, you may lose a substantial portion or all of your investment in the company. You may have signed a personal guarantee, which could put other unrelated assets you own at risk.

Review your loan covenants now. Don’t wait until it is too late and your loan is “called”. In most cases, you will not have enough time to find replacement financing and you could lose your business and your net worth. The worst time to borrow money is when you need it the most. If you have bad credit and/or a non-performing loan, the chance of getting a new finance source to advance money to you is very slim.

Review and manage your loans and their covenants. You need to know there may be a problem before anyone else does. Until next month, good luck!