For example, if the covenant is related to a drop in cash flows, then the borrower should be able to explain all the contributing factors. It is critical that the explanation for the default be specific and detailed. The lender will need to know whether this is a systemic issue or a one-time event. If you anticipate that a covenant default will occur, then the following actions should be taken:īefore communicating with the lender, the borrower should research the reasons for the default. Prudent CFOs should set up a process to ensure they regularly review their loan provisions and have projected out their covenant calculations for at least 12 months in advance. Despite how important these provisions may be, the lender rarely requires that these be reported on until they are tripped.Īs a result, many borrowers don’t pay attention to them because their focus is only on the regularly reported financial ratios. Loan agreements are littered with specific provisions that, when triggered, cause the borrower to be in loan default. Notably, financial and non-financial covenants incur the same amount of risk. For example, this could be the prohibition of borrowing additional debt, restrictions of liens, or financial reporting requirements. Non-financial covenants are provisions that govern corporate behavior and actions taken by management aside from operational performance measures. An example is a debt service coverage ratio whereby the cash flows of the business need to be at least 1.25 times the principal and interest payments on their debt. Financial covenants are ratios, limits, or thresholds put in place on the financial performance.If the borrower is unable to pay, then the lender can liquidate collateral or call upon guarantees to repay the outstanding balance.Ī loan covenant is a provision in a loan agreement that requires a corporate borrower to take a certain action, refrain from taking a certain action, or puts a prohibition or restriction in place for certain circumstances that may arise.Ĭovenants can be both financial and non-financial in nature: At best, the lender could choose to waive the default, often for a fee at worst, the lender could choose to increase pricing, add covenants, or simply call the loan in full. The moment a default has occurred, the borrower has effectively given full control over the consequences to the lender. Loan defaults should be avoided at all costs.
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