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Executive Summaries Jan 22, 2019

The Impact of Restrictive Covenants When Obtaining Bank Financing

No matter its size, sooner or later, every business will consider bank financing as an option for sustaining its growth.

Bank financing plays a significant role in sustaining a company’s development, its expansion projects, or its internal growth. Contracts formalizing relationships between lenders and companies are numerous. To ensure that loan agreements will be duly performed and to evaluate the likelihood of repayment and limit the risks associated with the loan, financial institutions will include restrictive covenants in their loan agreements. Under these terms, the borrower will guarantee, most notably, the company’s financial health and the performance of the loan conditions. Although there are many types of restrictive covenants, those most commonly used deal with the borrower’s financial disclosure obligations and the measurement of the company’s financial capacity.

It is important to properly understand the full scope of such undertakings, which create obligations of result.

Financial Ratios to Monitor Risk 

EBITDA 

Many financial ratios are calculated for purposes of evaluating a company’s financial health, so that financial institutions can monitor risk effectively. Accordingly, a company will often be required to comply with certain contractual financial measurements, for instance by maintaining specific financial ratios. EBITDA (earnings before interest, taxes, depreciation, and amortization) is a financial indicator on which lenders frequently rely to evaluate a company’s earnings before deductions or influence of interest, taxes, asset depreciation, and the amortization of capital expenditures. By using this indicator, the lender can monitor and compare data on the growth of the company’s earnings and profits.

EBITDA is usually calculated once a year, more precisely at fiscal year-end. The lender will consider a company to be profitable if the EBITDA calculation is positive. Accordingly, a company may be bound to meet a specific EBITDA calculation, as stipulated in a clause included in the commitment letter, and failure to meet it could place the company in default with the lender. The financial health of a company may also be measured by the evolution of its share value, market capitalisation, and general indebtedness.

Current Ratio

Another indicator valued by financial institutions is the working capital ratio, otherwise known as the current ratio, being the ratio of short-term assets to short-term liabilities. A financial institution might determine, for instance, that a company is in good financial health if its working capital ratio is higher than 1:1, meaning that it has sufficient assets to cover its short-term liabilities. However, it is worth noting that too high a working capital ratio, for instance 3:1, is not necessarily a positive indicator, since it could mean that the company has a surplus of obsolete inventory.

Capital Expenditure

Finally, it is also worth mentioning that clauses are also inserted in loan agreements to govern and monitor a company’s capital expenditure, or “Capex,” being the capital expenditures incurred by a company for the acquisition of physical assets for the purpose of improving its long-term productivity. Aside from the purchase of real estate, such expenditures will include every outlay deemed to be an investment in the business, such as the purchase of equipment, machinery, or rolling stock, which must therefore be listed on the company’s balance sheet.

Negative Pledges

Sometimes, under certain financing structures, a company will have to satisfy what is known in the financial community as “negative pledges.” Here are a few examples:

  • Not to grant, create, assume, or tolerate any hypothec, mortgage, security, or other charge on any of its properties, assets, or other rights without the lender’s prior written consent;
  • Not to sell, transfer, assign, sell, or otherwise alienate its properties or assets other than in the normal course of its business and according to commercially reasonable terms without the lender’s prior written consent;
  • Not to guarantee or otherwise act as surety, directly, indirectly, or potentially, for the payment of an amount or the performance of an obligation by another person without the lender’s prior written consent;
  • Not to proceed with an amalgamation, merger or other business combination without the lender’s prior written consent; or
  • Not to repay the debts owed to equity lenders.

To conclude, when it obtains bank financing, a company agrees to honour numerous terms benefitting the lender, which may be measured on a monthly, quarterly, or annual basis. Should certain covenants not be satisfied, thus causing the company to be in default of its financial undertakings, the financial institution could choose to modify the terms of the financial assistance or the rate schedule, or establish terms of extension. The financial institution might also decide to realise its conventional security registered against the company at the time of financing.

Accordingly, it is essential that a company properly understands and validates the nature and scope of its undertakings and the restrictive covenants when it enters into an agreement with a financial lender, to make sure it can comply with them.

 

To learn more about restrictive covenants, sign up for our Strategic Forum on Corporate Financing, which will be held on Tuesday, February 19, 2019 in Montreal and Quebec City.