Australian financial markets are constantly changing, however, one aspect of lending that remains the same is financial covenants, also known as debt covenants.
A financial covenant (also known as a debt covenant or banking covenant) is a condition or formal debt agreement put in place by lenders which limits the borrower’s actions. That is, specific rules a borrower must abide by.
A financial covenant is a condition or formal debt agreement a bank puts in place that the borrower is required to adhere to.
Positive debt covenants or affirmative covenants require the borrowing party to take specific action/s. The lending party implements positive debt covenants as part of the loan agreement.
Some common affirmative covenants include maintaining a good credit rating, insurance and appropriate accounting records.
Negative covenants ensure borrowers don’t do anything that could damage their credit rating or ability to repay their existing loan. Like a positive debt covenant, negative covenants are established as part of the loan agreement, and they can only be overridden by the covenant issuer, or lending party.
For example, the most common negative covenants restrict against or forbid actions such as issuing dividends and adding more debt to the business.
Financial covenants protect the lender by limiting the borrower’s actions and preventing them from taking actions that may increase risk for the lender.
Financial covenants provide the borrower with financial disciplines to ensure they don’t overextend themselves and put the business at risk.
Financial covenants vary from bank to bank, but broadly speaking, there are two main areas that the bank is trying to monitor:
If you are a business that has or is thinking of taking advantage of the instant asset write-off, you need to be mindful of the effects this will have on your bottom line over the next 12 – 24 months.
The total cost of eligible capital depreciable assets may be written off in the first year of use rather than at the usual depreciation rate over the asset’s life. While the benefit is that it results in a reduced NP position and, therefore, less tax, the reduction in NP may mean you breach the Bank’s financial covenants.
Without sufficient bandwidth, you may breach a covenant or put yourself under too much pressure. That is, the accelerated write off may impact a financial covenant such as a dividend policy/covenant where it is calculated pre-tax versus after tax.
Why does this make a difference? Well, if there is a “Dividend Restriction” covenant, it can make a big difference.
For example, let’s say the covenant is “Dividends, distributions are restricted to 30% of NPAT”. If you’ve applied accelerated Asset Write off and dramatically reduced your NPAT position, this could potentially reduce the amount you can draw by way of dividend.
Therefore, before purchasing significant assets, speak to your trusted accountant or tax professional to determine how it will impact your cash flow and finances in the short term.
It’s important to note that there are subtle differences amongst banks, so it’s vital that you, as the client, are aware of these and be mindful of the covenants you agree to.
Depending on your circumstances and industry, these financial covenants may need to be altered, or the lender may need to introduce a covenant better tailored toward the client and the loan agreement.
If there is a breach of a financial covenant, usually, the lender will send out a letter acknowledging the breach and advising that they reserve their right to take action.
The lender can legally call the loan, demand repayment in full, enforce a penalty payment, increase the amount of collateral, or increase the interest rate.
If the lender holds a GSA (General Security Agreement), this, coupled with debt covenants, can be quite powerful. Therefore, it’s important that debt covenants are appropriate and achievable before they are agreed to as part of the loan contract.
Please note the information provided here is general in nature and does not constitute financial, tax or other professional advice. You should consider whether the information is appropriate for your needs and seek professional advice prior to making any decisions.
