When an organization enters into a line of credit or business loan, it is common for the debt agreement to include financial covenants.
These covenants typically prescribe conditions that must be met on an interim basis (monthly, quarterly, semi-annually, or annually) in order for the bank to continue to provide the agreed-upon liquidity. Loan covenants are typically based on calculations of earnings before interest, taxes, depreciation, and amortization (EBITDA), net income, or other similar measures of earnings.
Referred to most commonly as a debt covenant, a loan covenant defines what the borrowing organization is required (and/ or forbidden) to do and the minimum financial metrics/ratios the organization is required to maintain for full compliance under the loan agreement.
Breaching a debt covenant can result in severe penalties, including the bank (or other lenders) “calling” the loan.
Any of the following circumstances may put an organization at greater risk of a financial covenant breach:
Financial covenant metrics and ratios are typically clearly defined and can be calculated as an organization closes the books. Borrowing base calculations, which are often based on levels of working capital, may reduce amounts available to borrowers under existing lines of credit. Borrowers should also be mindful of the accounting treatment of financial covenant defaults. Under certain circumstances, a covenant default may necessitate that the debt be reclassified from long- to short-term, which could then result in violations of additional financial covenants (such as liquidity ratios).
Borrowers should be familiar with the amendment and waiver provisions in their loan agreements, including the voting requirements for different types of amendments or waivers.
If a violation of a debt covenant occurs, the debt would generally get classified as current unless the lender provides a waiver that extends the payment out to at least 12 months past the current balance sheet date. The debt should, however, still be shown as non-current if the company is able to cure a violation after the balance sheet date but before the financial statements are issued. Additionally, some loans allow for a grace period; in this case, if the violation is cured during this grace period or demonstrated probable to be cured, the debt would continue to be classified as non-current.
Borrowers who anticipate that they may be in violation of financial covenants as a result of the economic effects of a crisis on their business should be proactive with their lenders to work through the option of obtaining waivers or permanent amendments. Loan agreements typically contain covenant reporting provisions that require the borrower to notify the lender of any defaults or events of default that have occurred.
Borrowers should be familiar with the amendment and waiver provisions in their loan agreements, including the voting requirements for different types of amendments or waivers.
As stated, a covenant violation can result in the calling of the loan, which has urgent ramifications for both borrower and lender. Impaired financial performance can likewise impact ongoing investor relations.
The below steps are proactive mitigation strategies in the event of a covenant breach that is challenging to avoid:
Following these steps will help organizations prepare to navigate the accounting and financial reporting considerations of a potential covenant breach in an effective and efficient manner.
Editor’s note: Updated January 2022
