Line of Credit Covenants
The fine print matters in small business loans. Line of credit covenants are particularly important and you'll need to understand these common credit line covenants before you take out a small business credit line.
Your company thrives on access to credit.
Without it, you will miss out on opportunities that are essential to your future growth. A business line of credit provides your company with a source of working capital to cover seasonal shortfalls and cyclical spending requirements as well as non-typical business opportunities. But business lines of credit also come with special caveats, not the least of which are line of credit covenants.
A line of credit covenant contains specific requirements that your company must meet in order to maintain access to line of credit financing. If you think line of credit covenants are only guidelines, you're fooling yourself. Failure to meet the stipulations outlined in an line of credit covenant will have consequences such as the loss of financing or a lender call on the entire outstanding balance.
Line of credit covenants can vary from one lending scenario to the next. Yet small business line of credit financing arrangements often include a handful of specific covenants:
- Net worth covenants. From the lender's perspective, net worth is an important ratio because it identifies the bottom line value of your business after all of your liabilities have been taken into consideration. If your company experiences a catastrophic financial event (i.e. bankruptcy), the lender's minimal net worth covenant provides some assurance that there will be enough assets to cover the line of credit balance.
- Interest ratio covenants. Lenders are concerned about their borrowers' ability to pay interest on the line of credit balance. At the end of the day, interest is their primary source of income and if it represents too large a portion of your total income, your ability to pay it may be in jeopardy. A common formula is earnings before interest, tax, depreciation and amortization (EBITDA) divided by annual interest expense. High interest ratios are better than low ones - if you dip below the level specified in the contract, it will trigger a breach of covenant.
- Debt ratio covenants. line of credit lenders want to make sure your company isn't strangled by debt, so they often include debt ratio covenants in the lending contract. This usually takes the form of a debt-to-EBITDA ration, with lower values indicating a more manageable debt load.
- Material change covenants. Material change covenants are the junk drawer of line of credit covenants - they cover a multitude of events that negatively impact your company's financial position. Carefully review the terms of material change covenants before you sign the line of credit contract.
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