Understanding Loan Covenants

by SST Senior Audit Manager, Bridget Losa, CPA

It is fairly common for loan covenants to be included in loan agreements, these covenants are part of the borrowers obligations to the lender. A loan covenant is a condition in a commercial loan that requires the borrower to fulfill certain conditions, or which forbids the borrower from undertaking certain actions, or possibly restricts certain activities in connection with the use of the borrowed funds.

Many organizations are not even aware that their loan agreements include covenants. At SST we encourage our clients to review their loan documents so that they fully understand their commitments to the lender before engaging in the contract.

There are three types of loan covenants:

  • Affirmative covenants: require you to provide information to the bank such as audited or reviewed financial statements by a certain date after year end or maintain a reserve account with a specified minimum balance.
  • Negative covenants:  prohibit you from certain actions such as borrowing additional funds or selling assets.
  • Financial covenants:  require that the organization maintain certain ratios such as debt service coverage, debt to net assets, or restrictions on capital asset purchases.

It is critical for borrowers to understand and fully comply with the covenants set up in their loan agreements so that they are not in violation of the agreement with the lender. Our dedicated staff of compliance specialists at Salmon Sims Thomas has the skills to assist you in navigating the conditions of your loan agreements. For help deciphering the terms of your loan, or for answers to your questions, contact me at blosa@sstcpa.com.