Today, borrowing money is a fundamental part of business. It enables business owners and managers to meet their business objectives as they juggle their way through accounts receivables and payables, major expenditures and more.
However, one aspect of borrowing can end up creating more work and accountability than you might expect. More importantly, it can limit your ability to stretch and grow. Loan covenants (commonly referred to as “debt covenants”) are terms within the loan that require the borrower to fulfill certain conditions or forbid the borrower from undertaking specific actions. Debt covenants are a standard part of most conventional loan agreements as a safeguard to protect the lender’s position. They are generally designed to ensure that the borrower remains financially stable and able to pay the debt. However, meeting the obligations associated with some debt covenants can also tie you up in regular excessive reporting and cap your ability to grow.
The good news is there are other ways to find the funding you require without getting bogged down in a world of restrictive covenants. In fact, by choosing the right lending partner, it’s more than possible to meet your business goals and live free from highly restrictive covenants that hinder the fiscal management of your company.
First, it’s essential to understand that not all debt covenants are the same. All loan agreements will contain some form of debt covenants to safeguard the lender’s position and provide clarity as to the borrower’s responsibilities. Debt covenants are generally affirmative or negative, documenting what the borrowing business agrees to do (affirmative) or not do (negative) over the course of the loan.
However, within the realm of debt covenants, a specific group is referred to as “financial” covenants. These specific covenants require the borrower to meet explicit financial goals each month. As a result, the lender gains a deeper level of scrutiny, allowing them to monitor and control the borrower’s financial decisions. In effect, this can tie the borrower’s hands, constraining their ability to expand and grow. Fortunately, alternative lending options are readily available that are free from these restrictive financial covenants. As a result, these options are better able to support, not restrict, the growth of your business.
With this basic overview in mind, this may be a good time to assess how your debt management demands impact your operations. And the first step in the assessment is to better understand the debt covenants that are a part of your current loans:
- Why they are needed.
- How they work.
- Whether they may restrict your decision-making to the point where you should consider alternatives.
Types of debt covenants
Debt covenants are generally categorized by two major types:
- Affirmative debt covenants – Requirements on a borrower to perform specific actions.
- Negative debt covenants – Requirements on a borrower to restrict specific actions.
What are affirmative debt covenants?
Affirmative debt covenants assert the borrower’s actions to be performed to maintain the financial health and well-being of the business.
Examples of affirmative debt covenants:
- Obligations to pay all payroll and taxes when due.
- Obligations to maintain all insurances required by law to operate the business.
Affirmative debt covenants are breached when the borrower fails to perform actions as specified in the contract.
What are negative debt covenants?
Negative debt covenants are put in place to restrict the borrower from performing specific actions.
Examples of negative debt covenants:
- Restrictions to prevent the compromising or devaluing of assets pledged as part of the contract.
- Restrictions to prevent the acceptance of payment for an invoice or other asset pledged to the lender.
- Restrictions to prevent the borrower from consolidating or merging with another entity without the lender’s consent.
Negative debt covenants are breached when the borrower exceeds limitations as specified in the contract.
What are financial covenants?
Financial covenants are put in place to monitor the borrower’s performance towards reaching specific financial goals through regular audits and ratio analysis.
Examples of these ratios include:
- Debt/EBITDA Ratio: A leverage ratio used to measure the borrower’s ability to pay off its debt.
- Dividend Payout Ratio: The dividends paid to shareholders in relation to the company’s total net income.
- Fixed-Charge Coverage Ratio: A measure of a company’s ability to meet fixed-charge obligations.
Financial covenants are breached when the borrower fails to meet financial goals as determined at the start of the contact.
Why are financial covenants needed?
Conventional lenders make credit decisions based on the company’s cash flow, financial performance, and operational performance. They then take all assets as collateral to mitigate risk. As these lenders are not in the business of collecting assets, they focus on ensuring borrowers remain able to pay their debt. Financial covenants allow the lender to monitor typically monthly and at times even micro-manage the borrower’s financial performance. The tight controls financial covenants impose may require regular financial reporting from the borrower and audits by the lender to ensure the loan stays on their radar as a safe investment.
How do financial covenants restrict growth?
Businesses in the process of expansion need additional capital above and beyond normal operating budgets. Investments in equipment, human resources, facilities, technology systems, training, marketing, and more are needed to create an infrastructure in which the business can flourish. As growth develops in stages, constant access to greater amounts of working capital is needed throughout the development. Too often, a company focused on a growth opportunity will breach a financial covenant without realizing it as they direct capital resources in contradiction to a financial covenant.
What happens when a financial covenant is breached?
If a financial covenant is breached, the lender will take corrective action, which could include blocking further credit to the borrower. At that point, the loan will likely be renegotiated with further conditions and restrictions implemented until the covenant is cured. If the financial covenant is not cured within a specified time, the loan will trigger a default. At this point, the borrower generally has only a few days to repay the loan in full, or the debt will be assigned to a debt collection agency. Defaulting will drastically reduce the company’s credit score, impact its ability to receive credit, and can lead to the seizure of assets.
So, how are your debt covenants doing?
Now that you have a clearer understanding of debt covenants in general, how they work, and why they exist, ask yourself, “how are your covenants doing?” Take a moment to review the debt covenants in place with your current loans. If you can’t decipher the details, speak with your lender and look for the answers you need. They should be forthright with those answers as debt covenants are essential for how lenders do their business. Once you have the complete picture, you’ll be better able to decide if your covenants are workable or if they could present a challenge down the road that you would rather avoid.
Suppose your answers suggest a future free of financial covenants is the preferred route. In that case, you may want to consider a more flexible lending solution designed specifically for your funding needs without unwanted covenant-based restrictions. Those options fall under the category of alternative lending solutions and come in many forms.
The flexibility of alternative lending solutions
As noted above, a conventional lender will base lending decisions largely on the financial performance of the borrower. If the borrowing company repeatedly fails to meet fiscal goals as defined in the financial covenants, the withdrawal of credit is imminent. Alternative lending solutions such as invoice factoring or asset-based lending (ABL) provide a far more flexible lending arrangement.
Benefits for the borrower
The lack of financial covenants contributes to the flexible nature of alternative lending. With the support of cash flow solutions designed to help businesses grow, borrowers are given every financial advantage needed to fuel business development. Unlike conventional lines of credit, when a company utilizes invoice factoring or asset-based lending to support growth, more credit becomes available as assets such as equipment, real estate, inventory, and invoice receivables increase. In other words, the more you grow, the more access to working capital you gain.
Industry-leading alternative lenders take active participation in supporting the growth and success of the borrowing company. Acting as financial partners to their borrowers, alternative lenders such as eCapital contribute resources such as:
- Faster access to working capital
- More credit with less hassle
- Supportive risk management
- Accounts receivable management
- Full transparency and accountability
- 24/7 access to online account portal
- Dedicated customer support
If you are concerned about the possible impacts of your existing debt covenants, or if you are looking at future borrowing, you should now understand what to look for, what debt covenants you can live with, and when it may be time to consider an alternative. In the right situation, the smart use of asset-based loans and invoice factoring can reduce your time worrying about current debt. It can help you increase your available time for business planning and goal setting. Deciding to work with an innovative and trusted alternative lender opens the opportunity to operate free of highly restrictive covenants, such as financial covenants, and better enables you to grow your business.
Since 2006, eCapital has been a trusted financial partner for thousands of small to mid-size companies in all stages of development. Our customer base continues to grow as our reputation for dedicated service and forward-thinking solutions to even the most complex situations endures.
As a leading industry innovator, eCapital integrates emerging technologies with a forward-thinking approach to solve business problems. Strategic partnerships and collaboration with VISA, the world leader in digital payment, bolsters eCapital’s push to extend the boundaries of flexible funding. eCapital customers benefit with access to more funds, faster, and with less hassle than competing lenders can provide.
For more information about asset-based loans and invoice factoring, and how they can help solve the complex issues of today’s business environment, visit eCapital.com.