When a company borrows money from a financial institution, they will have to sign a loan agreement that outlines the terms and conditions of the loan. One of the most important aspects of the loan agreement is the financial covenants. These are conditions that the borrower must meet in order to avoid defaulting on the loan. In this article, we will take a look at some examples of financial covenants in loan agreements.
1. Debt service coverage ratio (DSCR)
This covenant is used to measure a company`s ability to generate sufficient cash flow to cover its debt repayments. The DSCR is calculated by dividing the company`s net operating income by its total debt service. The lender will typically require a minimum DSCR of at least 1.25 to 1.5.
2. Loan-to-value ratio (LTV)
The LTV is used to measure the ratio of the loan amount to the appraised value of the collateral. This covenant is typically used in real estate loans. The lender will typically require a maximum LTV of 80% to 90%.
3. Current ratio
The current ratio is used to measure a company`s ability to pay its short-term liabilities with its current assets. The lender will typically require a minimum current ratio of 1.5 to 2.
4. Minimum net worth
This covenant is used to ensure that the borrower has sufficient net worth to act as a cushion against any potential losses. The lender will typically require a minimum net worth of 25% to 50% of the loan amount.
5. Interest coverage ratio
The interest coverage ratio is used to measure a company`s ability to meet its interest payments with its operating income. The lender will typically require a minimum interest coverage ratio of 1.5 to 2.
6. Capital expenditure restrictions
This covenant is used to limit the amount of capital expenditures that a borrower can make during the term of the loan. This is done to ensure that the borrower does not divert funds away from servicing the loan. The lender will typically require that the borrower obtain prior approval for any capital expenditures over a certain limit.
In conclusion, financial covenants are an important part of any loan agreement. They help to ensure that the borrower is able to meet its repayment obligations and that the lender is protected against potential losses. It is important for borrowers to carefully review and understand the financial covenants before signing the loan agreement.