What Are Some Normal Loan Covenants for Business Loans?
Posted by Bill McDermott on Mon, Apr 11, 2011 @ 07:52 AM
This was a question posed by a visitor to our web site last week and I thought it was a good one. If you are renewing your line of credit or taking out a new business loan, it's helpful to know what to expect from your bank or banker.
Just like real estate is all about location, location, location, loan repayment is all about cash flow, cash flow, cash flow. So, it's normal to expect a cash flow covenant. Banks are usually looking for you to have the ability to repay your loans and still have a 20-30% cushion. This is expressed in a term called cash flow coverage or 1.2-1.3x. Be sure you understand how cash flow is defined. Most often it includes profit, depreciation and any other non cash charges to earnings. Some banks include taxes, some take them out. Same thing with owners withdrawals or distributions. On lines of credit, most banks will define the coverage with the line fully extended, not just the usage. For a term loan or mortgage loan, it's 12 payments of principal and interest. Most banks define this term in their commitment letter, but if they don't it's important to ask. No surprises here!
Next, most banks care about how leveraged your company is. High leverage spells high risk to banks. Leverage is defined as the amount of debt (total liabilities) to the amount of equity (net worth). Most banks like to see about 80% debt to 20% equity. You might remember the 80-20 rule. The second covenant that's normal is a debt to worth covenant which I just explained.
The two covenants I just described are called financial covenants. The next type that's normal is non financial covenants. Probably the most common here is no change or ownership or management without discussing it with the bank. The reason for this is the bank may not feel the same way about extending credt if you sell the company or choose someone else to run it for you.
Beyond this, there may be specific situations that either describe your company or the bank's style where additional covenants may be added. But, these are the basics. If anyone has had a certain experience, please ask a question or leave a comment. I hope this answers the visitor's question.