Often when lending against a business, a condition of approval set by the Banks will be that the business operate within and/or meet certain Financial Covenants.
For business owners, unfamiliar with the concept Financial Covenants it can be a scary prospect!
It can be hard enough to run a business, meet interest and repayment obligations, without then having to also meet certain financial benchmarks with which you are unfamiliar!
What are Financial Covenants?
Generally, Financial Covenants are tools that Banks use to monitor the performance of a business.
They are constructed around the business financials (both historic and projected) provided in support of the loan application.
Typically, they could encompass things like:
- Balance Sheet Gearing (Minimum % of Net Tangible Assets to Total Tangible Assets)
- Minimum Current Ratio (Total Current Assets divided by Current Liabilities)
- Interest Cover Ratios (Earnings before interest and tax divided by interest)
- And more depending on the type of business and/or facilities provided
Business owners will be required to report performance against the covenants usually on either a quarterly, six monthly or annual basis – again, this will vary depending on the business, its circumstance and the type of borrowing.
What is the purpose of Financial Covenants?
Despite the picture often painted, Banks do not like having to realise (call up) security provided in support of lending. Nobody wins when this occurs – neither the Bank and certainly not the client!
The purpose of Financial Covenants is to provide early warning, to both the Bank and the client, of changes within the business that have the potential to adversely impact the business and by extension the Bank!
They are a “trigger” for discussion and allow for remedial action to be taken before the position becomes unsalvageable!
In my experience, Financial Covenants when used correctly, protect the interests of both the Bank and the client!
Covenants shouldn’t be a millstone around your neck!
Business is very dynamic, so it is important to ensure before accepting a Letter of Offer from the Bank that contains Financial Covenants, that you can actually work within the parameters that have been set.
Occasionally, Bankers may go with a standard suite of template covenants without realizing they may not suit your specific business.
If you have concerns, that you may have difficulty meeting a particular covenant, it is important to explain the reasons to the bankers involved before accepting the Letter of Offer
Bankers do not want to set covenants that will negatively impact business operations or trigger events of default – that is in nobody’s interest! So, if you have concerns outline the reasons why!
If a satisfactory compromise can’t be agreed, then don’t sign the Letter of Offer!
Financial Controls – a key to making it all work!
To effectively work with Financial Covenants as a business owner you need:
- Access to “real time” financial information
- Robust internal policies and processes
A few years ago, for many small businesses, it was costly to install the accounting software needed to effectively monitor the performance of a business. The software was also not all that user friendly!
But it is one thing to have access to great financial data, you also need supporting policies and processes within the business to ensure you achieve the outcomes you are seeking.
Even the best accounting packages in the world can’t compensate for a lack of clear policies that are not implemented!
Financial Covenants – What if a breach occurs?
If you identify that a breach of a Financial Covenant has occurred, or is likely to occur, it is important to get on the front foot and let you banker know:
- Why it has occurred
- How it can and/or when it will be rectified (This will likely require some fresh financial projections)
- How you will ensure a breach will not occur in the future
This approach is always far better than waiting for the Bank to identify the breach!
In my experience, bankers will generally work with clients with a view to rectifying the situation, allowing corrective action to be taken, as resorting to realisation of security is a scenario under which there are no winners!
At first, the concept of Financial Covenants may appear daunting for many business owners.
It can seem as though the Bank is “looking over your shoulder” and perhaps applying some “financial handcuffs” – however in my experience the reality is far different!
Financial Covenants when properly applied work in the business owners and the Banks interest – protecting both parties and providing early warning if things start to go “off-track”.
Early warning allows remedial action to be taken before the situation becomes unsalvageable, thus protecting both your business and personal assets.
At The 500 Group, a lot of the finance we arrange for our clients is against the business assets and as such we are very familiar working with Financial Covenants.
If you are wanting to borrow against your business or learn more about how Financial Covenants work, don’t hesitate to give me a call on 0400 239 611