Lenders, Borrowers and Covenants
There are three kinds of covenants:
- Affirmative (the borrower says, “I will do… this or that”)
- Negative (the borrower says, “I won’t do… this or that”)
Most lenders impose financial covenants as a way to measure performance; to make sure (in the lender’s mind) that a loan isn’t getting any more risky. The two most widely used financial covenants are debt to worth and interest coverage.
Debt to worth measures debt on the balance sheet vs. the net worth of the business. When looking at debt to worth, bankers typically look for a ratio of no more than 5:1. Asset based lenders allow much greater leverage as their concern is focused more on collateral than on the balance sheet.
The interest coverage ratio is earnings (EBITDA) divided by interest expense. Most lenders want to see a ratio of 1.25 or higher. Banks look at the higher end; asset based lenders at the lower end. This ratio determines a company’s ability to pay interest from earnings and is most important for interest-only loans.
For the most part, covenants are boxes to put a company in so that if it deviates, the lender can call it in default. Banks use them religiously, the concept being is that if a covenant is tripped, it goes to the health (or lack thereof) of the business. Some covenants are fairly tight such that any hiccup can trip one. If a covenant is tripped, there are a number of remedies the lender can take, including:
- Putting the loan in default and asking the client out
- Charging fees
- Increasing the interest rate
Business owners, when evaluating covenants imposed on their businesses, need to look and see how their business strategy plugs into those restrictions. They need to give serious thought based on expectations of how the business will perform and how that plays into those covenants. That’s one reason why detailed projections are so important.
Business owners especially need to understand covenants and their impact if their business is expected to have a tough or flat year because depending on the restrictions imposed, they might want to manage their expenses differently. At Celtic Capital, we don’t impose covenants. Our borrowers manage their businesses based on what’s best for the business, not to any restrictions imposed upon it. This makes it significantly easier for distressed companies.
As Banks will always have covenants, we encourage business owners who don’t have financial acumen themselves, or no strong in-house support, to talk with their CPAs or financial advisors and get “outside eyes” helping them to understand how covenants impact their businesses.
About Celtic Capital
Companies looking for working capital to cover operating expenses, fund growth, increase buying power and take advantage of vendor discounts and rebates turn to Celtic Capital. With an appetite for the more complex transactions, Celtic Capital has a history of success in crafting creative, flexible asset based financing solutions from $500,000 to $5 million with no financial covenants.
As an independent lender, working with companies nationwide, Celtic Capital is willing and able to alter price and deal structure and expand lines of credit to handle its clients’ increased revenues; and when cash flow is an issue, will look toward providing an inventory facility to help offset lost cash flow.