Finance Covenants

Tue 31st, May 2022 @ 11:12pm

What are Covenants in Commercial Lending?

Covenants in a banking context are restrictions or requirements that lenders place on the borrower.

These restrictions can be many and varied, both quantitative and qualitative, positive and negative and provide a structure for monitoring the performance of the borrower.

In the past, covenants were seen “as a guide” rather than a rule. In other words, as long as repayment commitments are maintained the noise between lender and borrower wasn’t “loud”.

In fact, our experience is that many business borrowers either are not aware or do not understand the basis of their ongoing covenants. Business owners need financial literacy in this area to prevent covenant breaches.  A savvy businesses will review performance regularly to maintain compliance with covenants.

Quantitative performance measurements include:

• Debt/EBITDA Ratios
• Interest Coverage Ratios
• Debt/Equity

Example in Bank Speak: 

Aggregated Actual EBITDA of ABC Pty Ltd will not for any Relevant Period be less than the respective Relevant Amount. Relevant Period and its respective Relevant Amount mean: A. 1 July to 31 December each year, $300,000; and B. 1 July to 30 June each year, $600,000.

Qualitative performance measurements include:

• Ensure assets are maintained and kept in good working order
• Dividend/Distribution Payout Ratio
• Limitation on new acquisition and/or merger activity

Example in Bank Speak:
ABC Pty Ltd will ensure that the sum of the Distribution and all other Distributions made in respect of each financial year does not exceed 100% of the NPAT.

All Credit providers apply different logic and scoring models, so these examples are perhaps simpler than the reality. However, the components of lending conduct are supported by these types of fundamentals.

More Information?