Knowledge Base - Banking & Financing
Bank Covenants an Early Warning System
Most loan agreements contain what are commonly referred to as Financial Covenants. These factors serve as an early warning system to alert both the lender and the company that the business may not be headed in a positive direction.
Normally the lender has certain rights to change the terms, or even call the loan if these covenants are violated. At a minimum, it gives the lender an opportunity to have a candid discussion with the borrower about what has happened and what their plans are to rectify the situation. The covenants can help to keep a business focused on improving areas were a lender sees the most risk. This is a good thing because it should lead to an improved relationship with this key “partner”.
Below we highlight three common Bank Covenants, as well as show how these indicators would quickly change in a business that is beginning to experience difficulties.
Debt Equity Ratio:
- Debt (total liabilities) divided by Total Equity.
- Shown as a relationship i.e. 4 to 1 or 4 : 1.
- The Debt to Equity Ratio shows how much the owners have at risk (Equity) as compared to the creditors (Total Liabilities).
- Depending on the type of business, 4 : 1 is normally considered good ( $2,000,000 of Liabilities compared to $500,000 of Equity) while 5 :1 or higher shows weakness.
Debt Service or Debt Coverage Ratio:
- EBITDA divided by Total Principal and Interest Payments.
- EBITDA = Earnings before Interest, Taxes, Depreciation and Amortization.
- Shown as a relationship i.e. 1.6 to 1 or 1.6 : 1.
- Indicates how easy it is for a business to meet its debt obligations out of earnings.
- 1.4 : 1 and above considered good, 1.0 and below viewed as showing weakness.
Times Interest Earned:
- EBITDA divided by Total Annual Interest Payments
- Similar to Debt Coverage Ratio, indicates a company’s ability to service its’ debt.
- Above 2.5 : 1 typically considered good. Below that shows weakness.
Given the above, consider this simple scenario…
A business is operating with a profit when it encounters a bump in the road that results in the following:
- Approximately a 10% drop in revenue.
- Due to high fixed costs and slow reaction time, expenses only go down nominally.
- Inventory increases.
- Line of credit and Trade Payables increase to make up for the revenue shortfall.
Click here for a representation of the financial statements and the indicators described above, both before and after the slowdown. This exact scenario happens to many companies every time there is an economic downturn. You can see how quickly the indicators monitored by the lender have deteriorated, and this provides an early warning that something has changed.