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What is a loan covenant? It’s a condition that the borrower must comply with in order to adhere to the terms in the loan agreement. If the borrower does not act in accordance with the covenants, the loan can be considered in default, and the lender has the right to demand payment (usually in full).

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What is a loan covenant? It’s a condition that the borrower must comply with in order to adhere to the terms in the loan agreement. If the borrower does not act in accordance with the covenants, the loan can be considered in default, and the lender has the right to demand payment (usually in full). Why do banks add covenants to the loan agreements?  They do this to maintain loan quality, keep adequate cash flow, improve financial weakness, and keep an updated picture of the borrower’s financial performance and condition. If you’re getting a bank loan, you should get to know these common loan covenants.

1. Maintain hazard insurance or content insurance

You may be required to keep insurance coverage on your plant or equipment or inventory in order to safeguard against the catastrophic loss of collateral.

2. Have key-man life insurance

This insures the life of the indispensable owner or manager without whom the company could not continue. The lender usually gets an assignment of the policy.

3. Stay up to date with payment of taxes, fees, and licenses

You’ll agree to keep those expenses up to date; failure to pay would result in the assets of your company being encumbered by a lien from the government, which would take precedence to the one from the bank.

4. Provide current financial information

You’ll agree to submit financial statements for continuing assessment by the bank. Financial statements are usually submitted yearly, while accounts receivable can be required every month.

5. Maintain minimum financial ratios

You’ll likely be required to maintain a certain level in key financial ratios, such as minimum quick and current ratios (liquidity), minimum return on assets and return on equity (profitability), minimum equity, minimum working capital, and maximum debt-to-worth (leverage).

6. Make no change of management or merger without prior approval

This guarantees the continuing existence of your business and will impede the deterioration of financial conditions due to a merger with an unknown entity.

7. No more loans without prior approval

This helps assure the bank that you will not take on excessive debt affecting the quality of the original loan.

8. No dividends or withdrawals or limited dividend withdraw

This occurs in situations where the net worth is being eroded by the extraction of capital in the form of dividends or stockholder’s withdrawals. The lender might find it necessary to restrict the amount of money that can be taken out of your company. In subchapter-S corporations, it is not uncommon to limit withdrawals to the owner’s tax liability.

Source: Loan Universe (www.loanuniverse.com)—This company has been providing independent free loan advice since 1998. Its objective is to help the general public understand how banks view their business or commercial real-estate credit requests. Contact: loanuniverse@loanuniverse.com.