Table of Contents
In Short
- Understanding Financial Covenants: Loan agreements often include financial covenants—promises to maintain certain financial metrics—to reduce credit risk and ensure repayment ability.
- Types of Covenants: These can be positive (requiring specific actions) or negative (restricting certain activities), with financial covenants typically being negative.
- Common Financial Metrics: Key metrics include EBITDA, adjusted EBITDA, cash, cash equivalents, liquidity, and cash reserves, which assess profitability and financial health.
Tips for Businesses
Before agreeing to a loan, thoroughly review all covenants to understand their implications. Ensure your business can consistently meet the required financial metrics to avoid potential breaches. Consulting with a legal professional can provide clarity and help negotiate favourable terms.
If you are a startup owner looking to acquire a loan, the loan terms will likely contain financial covenants. These loan covenants restrict your startup’s ability to act in specific ways. Put simply, a financial covenant aims to reduce your startup’s credit risk and ensure it can meet its obligations under the loan. This article will examine the most common forms of financial covenants in loan agreements and their consequences for your startup.
What Are Covenants?
In the context of a business loan, a covenant is any obligation in the loan agreement that requires you to do something. This is called a positive covenant. For example, the covenant “you must provide to your lender’s quarterly accounts” is positive because you must undertake a specific task to satisfy the obligation.
Alternatively, a covenant can require your business not to do something. This is called a restrictive covenant. For example, the covenant “you must not borrow additional money without the consent of your existing lender” is negative because it restricts your ability to do both. Financial covenants are typically negative covenants.
What Are Financial Covenants?
A financial covenant is a specific kind of covenant. The purpose of a financial covenant is to ensure that a startup’s management has effective financial metrics within a specific limit.
Financial Metrics in Financial Covenants
Financial covenants operate by reference to the following financial metrics.
| Metric | Explanation |
| EBITDA | This stands for earnings before interest, tax, depreciation, and amortisation. It is a standard measure of whether your startup has profit before it has settled any tax or interest obligations, as well as accounting for depreciation and amortisation, which are non-cash expenses. |
| Adjusted EBITDA | Adjusted EBITDA refers to EBITDA that accounts for unusual or one-off business activities that might otherwise make your EBTIDA figure unreflective of your business performance. |
| Cash | As the name suggests, cash refers to the amount of cash or credit in an instant access bank account you have on hand. |
| Cash Equivalents | Cash equivalents are those assets that behave similarly to cash. This includes public shares and other specific financial securities. |
| Liquidity | Liquidity is a measure of how quickly you can meet your current obligations. Sometimes, liquidity is measured by reference to your cash and cash equivalents. In some cases, liquidity may include other current assets like trade receivables. |
| Cash Reserves | Cash reserves describe obligations typically to keep a particular cash pool available. You may need to keep this in a separate bank account from other accounts. Alternatively, you may need to deposit cash reserves in a lender’s account. |
| Debt | Debt typically describes the value of all your startup’s non-current financial liabilities. It does not usually include any interest obligations due in the next 12 months. |
| Leverage | Leverage measures how much debt your startup has compared to equity. Alternatively, leverage may be compared to the value of your startup’s debt against your last 12-month (LTM) EBITDA. |
| Net Leverage | Net leverage is similar to leverage, but it reduces the value of your debt by the amount of cash or cash equivalents you have during the same. |
| Dividend Payout Ratio | This looks at the portion of earnings available to shareholders that your startup paid to shareholders in the form of a dividend. It then divides this figure by the total value of earnings available to shareholders. |
Minimum Liquidity in Financial Covenants
A minimum liquidity covenant obligates your startup to maintain a minimum amount of liquid assets. The definition of liquidity will be defined in the loan documents. For example, the covenant may state that your startup must maintain £1,000,000 comprised of cash or an undrawn line of credit.
Leverage Ratio in Financial Covenants
A loan agreement can express a leverage ratio covenant in different ways. For instance, it might state that your annual EBITDA must not exceed two times your net debt.
Cash Reserve in Financial Covenants
The loan may obligate you to maintain a cash reserve of £500,000, which you cannot access without your lender’s consent.
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Key Takeaways
Financial covenants or particular kinds of loan covenants. They require your business to maintain a sufficient level of credit and management. These covenants operate through particular definitions contained in your loan documents. Three typical financial covenants include:
- liquidity;
- leverage ratios; and
- cash reserve covenants.
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Frequently Asked Questions
Financial covenants are promises made by a borrower to a lender in a loan agreement to maintain specific financial conditions.
Lenders include financial covenants to monitor the financial health of a borrower and reduce the risk of default.
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