Loan Covenant Compliance

October 20, 2022 by Jason Kindseth
Outsourced Accounting and Advisory Services

Year-end is fast approaching and now is the time to make sure your company is in compliance with all loan covenants. Covenants vary, but the following discusses common affirmative covenants and how to ensure compliance. Business owners/managers should review their loan documents before signing to make sure they understand covenants and how to ensure compliance.

Financial statements – Many loans require financial statements (Audited, Reviewed, Compiled, or Company Prepared) to be provided to the bank within 90-120 days after year-end. If this is a new requirement, make sure your company has engaged a CPA to provide the required Assurance work. Engage the CPA now, before their busy season schedule is full, and make sure they are aware of the deadline.

Tax returns – Furnishing completed tax returns are another common loan covenant. Timing is generally a little more flexible as lenders realize that tax returns can require extensions for many reasons. Know the due date for the business and individual tax return(s) your lender is requiring and make sure your tax preparer is aware of the deadlines well in advance.

Minimum income requirements – Watch for minimum income requirements on Financial Statements or Tax Returns. A bank might require a certain minimum amount of income shown on either one, even if the borrower is making all required payments. This covenant can impact tax planning so make sure your tax preparer knows if you need to show a certain level of income.

Personal financial statements – Loans can require owners/guarantors to provide annual personal financial statements (PFS). These PFS are generally on a form provided by the bank and include a wide range of personal assets. Homes, retirement accounts, investments, and vehicles are among the assets included. Debts are included as an offset to get to personal Net Worth. Generally, PFS are prepared by the individual, but an accountant can provide guidance and answer questions if needed. Some PFS are Compiled by CPAs.

Debt Service Coverage Ratio (DSC) – This covenant is used to make sure the borrower has the cash flow to cover their annual debt service (principal & interest). A ratio of 1 means the company has just enough cash flow to cover their debts, generally lenders would require a higher amount. This is one of the trickier covenants as it can be before or after owner distributions (or both) and it can be based on Financial Statements or Tax Returns. Given the current tax laws and the goals of tax planning be minimizing tax liability (and generally, taxable income), it is important to know how this covenant will be calculated by the bank and manage accordingly. Owner distributions may need to be delayed or tax strategy changed to make sure your company maintains compliance with DSC covenants.

Tangible Net Worth – Tangible Net Worth is generally equity minus intangible assets (Goodwill, Customer Lists, Non-Competes, etc.)  Lenders want to make sure equity is moving in a positive direction (or staying consistent) and institute Tangible Net Worth requirements to make sure the borrower keeps equity at certain levels. Equity that arises from intangible assets doesn’t have value to a lender, hence the use the Tangible Net Worth vs. Equity. Once you know your required amount of Tangible Net Worth, calculate periodically to make sure your company is headed in the right direction.

Paying line of credit to $0 for X days – Loans can require the company to pay their line of credit down to $0 for a certain amount time each year (30 days, 60 days, etc.). Lenders do this to make sure the line of credit is used for seasonal cash flow needs vs. other uses. If your loan has this requirement be sure to have a plan for the time the line will be paid off each year.

Working Capital of $X – Lenders can require that borrowers show Working Capital of $x at year or quarter ends to make sure they have the liquidity to cover their obligations. As the Working Capital calculation is a snapshot in time borrowers should be aware of when this is measured and plan cash flows accordingly to maintain compliance.

Insurance – Almost all loans require the borrower to maintain adequate insurance on the collateral or business as a whole. Not only is this a covenant, but it is also good general business practice. Maintain proper insurance on your business assets.

Negative Covenants – Negative Covenants are to prevent borrowers from taking certain actions without the approval of the lender. Selling assets, taking on additional debt, or change in ownership are all things that can trigger default under Negative Covenants. Borrowers should know the negative covenants and get lender’s written approval before taking any actions that could violate Negative Covenants.

Loan covenants can be the difference between continuing in business and insolvency for borrowers that do not meet the requirements of their loans. Borrowers should understand all covenants before entering into loan agreements and make sure to calculate requirements regularly to ensure compliance.

If you have any questions on loan covenants, please reach out to me or another Copeland Buhl team member in advance of year-end.