You may remember the covenants you signed up for along with your bank loan or line of credit. They are the guidelines or what you do or don’t do in order to maintain good status on your loan, and they are created based on the financials you submit to the lender for underwriting. These covenants may be ratios like a fixed charge coverage, or your ability to pay your fixed charges based on your earnings. A decline in revenue could throw off your ratios and take you into the danger zone of breaching your loan covenants. When this happens, you are in default on your loan in the same way you would if you missed a repayment.
What Happens When a Covenant Is Breached?
The lending institution, like a bank, would have the right to raise your interest rate, demand advanced payment on the loan, or even demand payment in full. This is because loan covenants are in place to protect the lender from the borrower not repaying the loan. Financial covenants serve as an agreement between the borrower and lender on expectations of financial health and the ability to repay the loan. They affect the interest rate you are borrowing at, and the lender uses them to determine the amount of capital that you have access to.
Consequences of Breaching a Covenant:
- A penalty or fee
- Increased interest rate
- Increase in collateral
- Ending the debt agreement
- Waiving the violation without serious consequences
Breaching these covenants raises a flag to the lender that the borrower is in sticky financial health and may not be able to make loan payments anymore. Be sure to project your cash flow by creating a simple 90 day cash flow forecast or by using an outside cash flow tool. When having a conversation with your loan officer, you can use these projections to show how you will be able to meet the requirements of the loan agreement going forward.
Could You Lose Financing if You Breach a Covenant?
You can lose access to your financing if you breach a loan covenant. This is because the lender is trying to mitigate their risk, and breaching a covenant shows that you’ve become a risk. This is a worst case scenario for a small business with a bank loan or line of credit. Losing access to crucial financing that your operations depend upon could put you between a rock and a hard place when it comes to finding more capital to keep your business going. Sometimes breaching a covenant can be a quick fix, and it’s important to have open communication with your lender about any possibilities of violating your loan agreement. If you have this honesty and trust established between your lender and yourself, then you may be more likely to solve the offending issue and they could waive the violation without imposing any harsh reparations.
What to Do if You Lose Access to Your Financing?
If you experience a sudden drop in your revenue from internal or external causes (an economic downturn or the result of the COVID-19 shutdown) then you may be at risk of breaching your financial covenants. It’s crucial that you take measures to improve your cash flow. With healthy cash flow, you can work to balance the ratios that are outlined in your lending agreement and prevent from defaulting on your loan.
How Can You Find Fast Financing to Meet the Terms of Your Lending Agreement?
First, have a discussion with your lender about your financial health. See what areas you need to improve upon, and ask if they recommendations on raising your performance standards. Next, consider a source of financing that will not add to your debt. If you are at risk of breaching your covenants, then you will want to avoid adding more debt to your balance sheet. Invoice factoring services are a form of financing that improve your cash flow without adding to your debt or schedule of repayments. Healthier cash flow means a better ability to pay your creditors.
Why Accounts Receivable Funding Helps Borrowers Meet the Terms of Their Lending Agreements:
Invoice factoring, or accounts receivable funding, is a cash flow solution that is debt free. Factoring facilities are fast and flexible depending on the business’ needs. The application process typically takes a week or less, and funding starts immediately upon invoice submission. That means that the same day your goods or services are delivered, you have money in your account. This form of funding helps small businesses pay their fixed expenses like payroll, rent, utilities, and loan repayments. In addition, you will have more cash on hand to cover costs like supplies and extra labor in order to make more sales and grow your business.
Invoice factoring services are: