Loan Covenants Tighten Up


In the first quarter of 2009, 22% of CPA financial executives said previous sources of credit had dried up, according to the AICPA/UNC Kenan-Flagler Economic Outlook Survey. As a result, many businesses are shopping for new loan sources. Consider the following before you talk to a lender:

 Negotiate and monitor ratios. You know your business better than your lender does. Covenants usually include a loan-to-tangible-net-worth ratio and often quick-and-current ratios. Banks used to pad ratios by 20% to give the borrower wiggle room, and the borrower would have to be out of compliance for two consecutive quarters to be in default. “I’m not seeing those kinds of things being done anymore,” says Sam Thacker of consulting firm Business Finance Solutions. However, Thacker says ratios can be negotiated upfront. Ed Lette, CPA, chairman and CEO of Austin-based Business Bank of Texas, says in order to be prepared for a ratio discussion with potential lenders, look up ratios provided by the Risk Management Association. Most importantly, track your key financial ratios monthly.

 Prepare to be audited. “In the last 12 months we are seeing a trend where smaller companies are being asked to provide audited financial statements more than ever before,” Thacker says. Although it is important to consider all costs associated with maintaining loan covenants, for an unaudited business to provide audited financial statements—especially for the first time—is a major undertaking that can be very costly. It will take many hours of staff and management time to formalize accounting policies in accordance with GAAP, train staff, and set up and test internal controls.

 Watch out for a positive cash flow covenant. “One new covenant that I’m seeing is ‘Maintain positive cash flow measured on a quarterly basis,’ ” Thacker says. If your business cycle is longer than 90 days or you are borrowing against lagging accounts receivable, this could be an unacceptable covenant for your business.

 Get ready for new rate structures. Rate calculation has changed dramatically in the last six months, according to Thacker. Traditionally, operating loans and lines of credit have used a prime + X% rate structure. “As prime went down, many lenders put a floor in place,” he says. Many are also now using the higher of the prime rate as published in The Wall Street Journal or Libor (the London interbank offered rate).

 Be prepared for more stringent “personal guarantees.” The old standard was that owners who had a 20% or higher stake were required to sign guarantees, Lette said. Now many lenders require guarantees from 5% owners and even lower, depending on the company’s structure. U.S. managers of foreign-owned companies are also likely to be asked to sign personal guarantees.

 Know what’s typical. Typical affirmative loan covenants include the requirement to maintain various kinds of hazard insurance such as property and general liability and to maintain “key man” life insurance on certain managers. It is common for the lender to require submission of quarterly or monthly financial statements, the annual corporate tax return and guarantors’ personal tax returns. Shareholder loans to the business typically must be subordinate to the loan, and the lender will require you to maintain liquidity and performance ratios. All taxes and state fees must be paid and kept current.

For operating capital loans, lenders will typically want a monthly report of accounts payable and accounts receivable as well as copies of IRS Form 941 (payroll taxes) payments and quarterly 941 filings.

Negative loan covenants typically prohibit: changes in management or a merger without the lender’s permission; a distribution of profits without prior lender approval; further loans from other sources without lender approval; an increase on an owner’s annual draw or distribution without prior lender approval; and the sale of equipment without prior lender approval.

—By Matthew G. Lamoreaux, JofA senior editor. His e-mail address is


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