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Understanding Bank Loan Covenants

Bank Loan Covenants

While at a construction client doing preliminary audit work, in which the client had recently entered into a new loan agreement with a bank and the first question I asked them was, “Are there any financial loan covenant ratios you have to adhere to as part of the loan agreement?”
I was expecting the client to say “Yes here are the financial loan covenant ratios and we are in compliance and met the ratios.” The response I got was, “what do you mean financial loan covenant ratios?” Right then and there my heart dropped with a sinking feeling. The first thing I did was read through the client’s loan agreement to see if there were any financial loan covenant ratios and sure enough there was and the sinking feeling had gotten further deeper. Luckily for them after reviewing and testing the client was in compliance and all was right in the world after that but man that could have been a nightmare had they failed a financial ratio covenant for the client as well as the audit team. Almost every loan agreement made with a bank will carry some type of covenant, either affirmative or positive loan covenants or restrictive or negative loan covenants in nature. Failure to be in compliance with financial debt covenants by any amount may technically result in a loan default, which can have serious consequences. And here lies the importance of understanding bank loan covenants specifically for the construction companies.

A loan covenant is simply a clause in the loan agreement that requires the borrower to do or refrain from doing, certain things. Affirmative or positive covenants are things that the borrower must do or agree to during the life of the loan. Examples of affirmative or positive covenants may include pay taxes and other liabilities due, maintain accounting records in accordance with Generally Accepted Accounting Principles (GAAP), maintain business insurance, maintain your collateral, provide audited financial statements (normally within a specified time) and probably most importantly maintain certain levels of particular financial ratios. Restrictive or negative loan covenants place limitations on what a borrower can do. These limitations often depend on the level of risk on the borrower. The most common restrictive or negative covenants involve repayment terms, the use of collateral and the borrower not to borrow any money from another lender.

Whether restrictive or protective, the loan covenants required by banks are generally associated with financial benchmarks or ratios. There are numerous benchmarks, ratios and metrics you can use to measure a borrower’s performance. Monitoring these benchmarks and financial debt ratios regularly helps the borrower or lender address problems early enough and will also assist in maintaining bonding capacity and making sure the company or borrower is in compliance with the covenants of the loan. These ratios include a variety of matters but typically include measures of profitability, liquidity, leverage and efficiency.   These covenants can be tested monthly, quarterly or annually depending on the loan agreement. Examples of a few loan financial covenant ratios for construction companies:

Debt Service Coverage Ratio

This ratio is a cash flow measure that reflects a borrower’s ability to service its debt obligations. Banks and sureties often require a covenant equal to or greater than 1.20x.

Working Capital Ratio

This ratio is the amount of funds invested in a borrower’s cash, contracts receivable and other current assets and it is calculated by subtracting current liabilities from current assets.

Current Ratio

This ratio measures a borrower’s ability to meet its current obligations and the higher the ratio, the greater the firm’s liquidity. Measured by dividing your current assets by your current liabilities banks and sureties typically like this ratio to be greater than 1.25x.

Debt to Equity Ratio

This ratio determines the extent of non-equity capital used to finance assets and calculated dividing total debt by total stockholder’s equity.   Lenders and sureties will vary on this ratio depending on the contractor.

One specific to the construction arena might be the following:

Months in Backlog Ratio

This ratio measures the number of months before all work under contract will be completed and is calculated by dividing total contract backlog by the average monthly revenue. Banks and sureties may see a ratio of less than 12 may indicate that the company needs to get additional work to maintain consistent revenues.

One of our most important functions as accountants or auditors is to be sure the company or borrower does not fail or breach any of the loan covenants. If an auditor discovers that a company is not in compliance, accounting standards require that the financial statements disclose the covenant violation. Now the lender can agree in writing to waive the ability to enforce the loan covenant but the severity of the failed covenant can range from calling the loan to raising the interest charged to the loan or some type of one-time financial penalty.

All construction companies should have a plan for monitoring the bank loan covenants. To avoid noncompliance, know the status of all your covenants at all times and keep an open dialogue of communication with the bank or lender. Best practices for monitoring all covenants are as follows:

  • All covenants, regardless of significance, be identified within the loan agreement.
  • Once identified, a comprehensive loan covenant checklist should be prepared containing the following information: Section reference to the loan agreement, brief description and definition of the covenant, how frequently tested, who is responsible and model covenant ratios along with the due date calendar of deliverables.
  • Have a compliance team or senior management review all work.

Understanding bank loan covenants is very important to all businesses big or small. Keep your auditor or accountant in the loop when negotiating new loan covenants and when there are any significant changes that may impact your company or company’s covenants. Your accountant can help you put together a comprehensive loan covenant checklist. WithumSmith+Brown, PC (WS+B) has vast banking relationships and can no doubt assist you when it comes to maintaining and negotiating loan covenants.

If you have any questions in regards to bank loan covenants please contact a member of Withu’s Construction Service Team at 973-898-9494 or 732-842-3113 constructionservices@withum.com

 

To ensure compliance with U.S. Treasury rules, unless expressly stated otherwise, any U.S. tax advice contained in this communication is not intended or written to be used, and cannot be used, by the recipient for the purpose of avoiding penalties that may be imposed under the Internal Revenue Code.

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