By Brendon S. Crossing
The Daily Record Newswire
A financial covenant is an agreement or promise between a financial institution and a borrower.
Covenants can represent an agreed action to be taken (positive covenants) or a prohibited action (negative covenants). A bank uses financial covenants to monitor and track the financial condition of a borrower.
I always explain to my clients that our relationship — the relationship between a bank and a borrower — is a partnership. A bank wants to see a business perform well. Covenants should be designed with that goal in mind.
Banks perform a high level of due diligence, or underwriting, on a borrower when deciding whether to extend credit. (Not surprisingly, borrowers recently seem to be doing a lot of due diligence on their banks.)
During the underwriting process, the company’s profit and loss statement and balance sheet are analyzed. The structure and composition of these statements can be revealing. What are the revenue and gross profit margin trends? How does this compare to the industry? What does cash flow look like? Can the company generate sufficient cash flow to pay its debts? Is growth hurting cash flow and, if so, is this growth manageable?
Understanding the answers to those questions is an important element in understanding the risk inherent in the relationship. Once identified, it’s important to mitigate those risks.That can occur through the implementation of covenants.
For example, our underwriting might demonstrate a company’s debt-to-worth ratio — total liabilities divided by total net worth — has been increasing (worsening) over the past three years and recently exceeded the industry average. After discussing the trend with management, together we might decide that a maximum debt-to-worth covenant is appropriate.
It’s important that management understands why it’s important to monitor the company’s leverage, and why an increase in leverage represents an additional risk to the owners of the business and the bank. Covenants are intended to protect the bank and the borrower. If it’s not feasible for a company to make a dramatic change in the debt-to-worth ratio, or any ratio for that matter, it might be appropriate to implement a step-down approach. In that case, management and the lender can decide where the company should be, then what incremental improvement is achievable on an annual basis.
Although banks use many different financial covenants, most are defined according to generally accepted accounting principles. I find it easier for all parties to understand when the covenant contains terms that are included on the financial statements. Another covenant used frequently is a minimum current ratio — current assets divided by current liabilities.
A current ratio is a measure of the company’s ability to meet short-term obligations. A high current ratio means the company is more liquid which translates to a lower level of risk. A low current ratio means the company might have difficulty meeting its short-term obligations. When looking at accountant-prepared financial statements, it takes no more than 15 seconds to calculate a current ratio.
A more complicated ratio that many commercial banks use is called the debt service coverage ratio. The DSCR is a ratio of cash available from operations to annual debt service. Generally it’s calculated as (net income + depreciation + amortization + interest expense) / (principal repayments + interest expense). Unlike the current ratio or other balance sheet derived ratios, the DSCR is calculated using information from the profit and loss statement, therefore it reflects a company’s performance over a period of time, typically one year.
A DSCR ratio of less than 1.0:1 means cash flow was not sufficient to cover debt payments throughout the year. A DSCR ratio greater than 1.0:1 means cash flow generated from operations exceeded the total debt payments throughout the year. Banks typically include a covenant requiring a minimum DSCR of 1.2:1. If I had to point to one ratio used most widely within our industry, the DSCR easily would be it. During the underwriting process, the DSCR is examined for all commercial borrowers, so it is beneficial for business owners to understand what impacts their DSCR, and monitor it.
Covenants convey an expectation of performance to management. That being said, it’s important for the lender and the business owner to craft appropriate covenants that are achievable and meaningful.
Once established, it’s also important for the lender and business owner to monitor covenant compliance on a regular basis. As a lender, it’s always enjoyable to sit down with a borrower at the end of the year and demonstrate the covenant we established was met and resulted in an improvement in the company’s financial condition.
Brendon Crossing is vice president, commercial services for Canandaigua National Bank and Trust. He can be reached at firstname.lastname@example.org; or (585) 419-0670, ext. 50638.