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What is a loan covenant?

How do lenders ensure that they're protected when they provide loans to borrowers? By the same token, how do borrowers ensure clarity when it comes to their expectations of the lender? Simple: loan covenants. As an agreement that determines the conditions by which a loan is extended, bank loan covenants are immensely important for lenders and borrowers alike. But while loan covenants might sound fairly simple, it's crucial to have a solid grasp of how they work and the potential consequences that could arise from a loan covenant breach.

Find out everything you need to know about loan covenants, starting with our loan covenant definition.

Loan covenant definition

In essence, a loan covenant is a promise, spelling out the terms and conditions of a loan between borrower and lender. As part of a loan covenant, the borrower will promise to remain financially sound for the duration of the loan. The lender will also state expectations regarding the borrower's capital structure and debt regarding loan repayments. As such, bank loan covenants will forbid borrowers from undertaking certain actions or require them to fulfil specific conditions. Ultimately, bank loan covenants help to protect the borrower's earning assets, ensuring that they're always able to generate the revenue they need to make loan repayments.

There are essentially three types of loan covenants: positive loan covenants, negative loan covenants, and financial loan covenants. Here's a little more information about each one.

Understanding positive loan covenants

Positive loan covenants (also referred to as affirmative loan covenants) remind borrowers that they should be carrying out specific tasks/activities to ensure their business's financial health. Affirmative loan covenants examples include the requirement to pay all business/employment-related taxes, maintaining adequate insurance policies, and maintaining accurate financial records.

Understanding negative bank loan covenants

Negative loan covenants are used to create boundaries/firewalls around certain ownership or financial matters. Some negative loan covenants examples include limitations to the total amount of debt the business can hold, restrictions on shareholder dividends, prevention of acquisitions or mergers without the lender's express permission, and so on.

Understanding financial loan covenants

Financial loan covenants are used to measure how well the borrower performs against the financial projections set out by the CFO, owner, or management. The closer the business is to these targets, the more satisfied the lender is likely to be. There are plenty of financial loan covenant examples, including the current ratio and the borrowing base calculation (which determines how high a business's line of credit can be).

What happens after a loan covenant breach?

If the borrower violates the loan covenant – referred to as a loan covenant breach – there may be a number of different consequences. Depending on the severity of the offence, the lender may simply create a waiver to accommodate the issue. However, more serious violations may cause the lender to suspend the loan, seize assets that you provided as collateral, demand earlier repayments, or initiate legal action. Furthermore, loan covenant breaches may lead to lenders charging hefty additional fees to cover any extra costs that they have incurred.

Bottom line: making a bank loan covenant work is all about good communication between the borrower and the lender. By staying in close contact with the lender, businesses can ensure that loan covenant breaches can be resolved as quickly and amicably as possible, while also understanding what went wrong and how to avoid doing so again.

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