Bank loan covenants are basically used to establish certain measures in order to make sure that your organization remains healthy financially and, most importantly, to make sure that the investment made by the banks remains protected. Loan covenants are categorized into two broad types, namely financial covenants or restrictive covenants, which can be further classified into affirmative or negative.
When it comes to affirmative covenants, your organization will be required to meet up with certain requirements imposed by the lending bank, such as maintaining a minimum level of profitability, revenues, or liquidity. The main aim of negative covenants is to hold you back from performing certain actions, like including more debt, replacing top management, or making more investments, without approval from the bank.
Following are some of the major loan covenant types that you will come across when taking out a business loan from a bank:
Financial covenants are typically restrictions established on certain cash flow items, income statement, or balance sheet. These types of covenants happen to be the most widely and commonly used types when it comes to business installment loans for bad credit agreements. In general, a financial covenant assigns a minimum level of liquidity or equity that has to be maintained by the borrowing organization.
Operating Activity Covenants
These covenants dictate the way you operate your business. Most of these covenants will require you to continue operating your business, abide by the laws and regulations, and regularly make business tax payments. Some of these covenants might prevent you from making use of the proceeds from your business, like your business capital and profits, for specific purposes without approval from the bank.
Preservation of Collateral or Seniority Covenants
These covenants will require you to properly maintain the collateral which you have pledged to obtain the loan proceeds and also to ensure that the senior lien position of the bank remains intact. You will have to maintain your equipment and property according to the standards set by the bank, and in some cases, you might be required to take out casualty insurance as well.
Cash Payout Covenants
Cash payout covenants restrict you from transferring wealth with any other co-owners of your firm. These payments, in general, restrict prepayment of debts, dividends, and also prepayment of your bank loan. Such covenants can even prevent you from buying out a shareholder or partner, in the event of his or her death.
Management, Control and Ownership Covenants
Management, control and ownership covenants confine the structure of governance of your firm, holding you back from merging with other companies, transferring the ownership of your business, consolidating your business, or changing your board or management without clear approval from bank.
Good news for you to know is that you can negotiate covenants with your bank before you proceed with signing your loan agreement. But remember that once you sign the agreement, you must comply with the points mentioned in it, without any second thoughts or disputes. Therefore, it is important that you completely go through and understand what is given in your covenant before signing the agreement.