Before signing any documents for a business loan, pay attention to the covenants. Loan covenants can be affirmative, things the lender requires you to do, or negative (restrictive), things you can not do without the lender’s prior approval. It is critical that you understand the covenants set forth in your loan documents; violating a loan covenant is a default under the agreement and the lender can choose to call the loan or take other remedial action.
Affirmative covenants include providing financial statements to your lender on a regular basis and carrying certain insurance policies, while negative covenants include restrictions against borrowing from another source, making management changes and selling collateral (other than inventory). There are any number of covenants that may be included in your loan documents, these are just a few possibilities.
Financial covenants require your company to maintain certain financial ratios, such as those pertaining to working capital, net worth, debt, profitability and cash flow, which are calculated based on your financial statements.
In addition to the more traditional business loans, there is also the business line of credit. The LOC typically includes a borrowing formula based on a certain percentage of current accounts receivable.
Loan covenants are the lender’s way of attempting to limit its risk, and are therefore not to be taken lightly.