See the major types of loan covenants, successful management, and more in under 5 right here
Every business’s goal is to grow and make increasingly healthy profits. One way to fund growth is to take up a loan. Every loan request is granted by a lender, such as a bank after certain loan documentation is signed by both the business (borrower) and the lender. It is vital to read and understand the terms and conditions of each loan agreement. Those are included in a loan covenant, in which you can get a professional covenant management service to help you convince and negotiate with the lender for fair T&Cs.
These kinds of loan covenants are legally binding.
Why are covenants included in loan agreements?
The lender has to protect themselves from financial ruin so they include a covenant to secure their interests—ensuring the borrower understands and is committed to repaying the loan to the fullest.
To do that, the financial covenant gives the lender rights to take actions and do things that would ensure the borrower’s business is in a healthy financial position so it can clear its loan with the lender.
One of those actions is monitoring and remedying problems at the borrower’s organization—from the earliest signs—to ensure the organization’s financial performance hits a particular threshold and can consistently pay what it owes creditors.
Yet, the importance of financial loan covenants is also beneficial to the borrower.
It helps the borrower to understand their obligations, and know what they need to do to be in a harmonious relationship with the lender.
That includes specific agreements that require the borrower to run their business in a way that will help it repay the loan.
What types of loan covenant management are there?
To understand the different types of loan covenant management, first, see the major types of loan covenants.
The three types of financial covenants are:
1. Financial loan covenants
There are four types of financial loan covenants under this option.
- Cash flow: where an organization’s surplus cash flow is measured to find out if it can service debt
- Borrower’s liquidity: cash-on-hand, securities (marketable), inventory, and receivables. Your loan covenant management service measures the balance sheet ratios at a specific point in time and compares that over a stretch of time
- Net worth: Also measured at a particular time versus over a while, net worth is referred to as the liquidity value and is the total measure of assets minus liabilities.
- Borrower’s leverage: loan covenant managers refer to it as the ratio of debt outstanding versus to cash flow
A good loan covenant management provider should do due diligence to ensure the client is getting the best from all the covenants.
1. Affirmative
This describes covenants where the borrower is reminded to take specific actions to ensure the well-being of their organization’s financial health.
They are usually “I Will…” kind of agreements, describing the positive deed the borrower will stick to, for example, keep records of accurate financial reports, pay tax obligations, and provide an enabling environment for top performance.
2. Negative
Negative covenants introduce limitations to the borrower such that the lender should be consulted before making decisions that affect the activities covered under the negative covenant.
It can be described as an “I Will not…” kind of financial agreement. For example, the lender can limit how much dividend is paid out, how much allowances the management earns, and prevent acquisitions and mergers attempts that the lender has not been consulted about.
What happens if you break a loan covenant?
Breaching a loan covenant may cause the lender to demand back the full amount of the loan. They can do so legally through a court of law.
Keep in mind loan covenant details can be negotiated. It is vital to have a professional loan management service guide you through the legally-binding financial agreement between you, the borrower, and the lender to ensure a win-win for both sides.
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