It is common for those who lend money to impose conditions or covenants on the business.

Failure to meet these covenants could, depending on the precise contract between the lenders and the business, give the lenders the right to immediate repayment of the loan. Typical covenants include: a restriction on dividend levels; maintenance of a minimum current asset/current liability ratio; a restriction on the right of the business to dispose of its non-current assets; and a restriction on the level of financial (capital) gearing.

Some examples of typical financial covenants are:

Maintenance of minimum working capital and debt service coverage ratios Maintenance of minimum net worth Restrictions on other borrowings, shareholder salaries, distributions, or dividends Limits on borrowing bases

In addition, lenders usually establish other covenants, sometimes labeled non financial in the loan document, such as requirements to:

Provide annual audits or reviews by a certified public accountant Provide interim unaudited financial statements and other financial information Maintain minimum levels of business insurance

Certain covenants can be very restrictive. (e.g. lenders might restrict capital expenditures, thus curtailing the companys ability to generate or increase revenues and cash flows). Typical financial debt covenants are

Interest cover, equity ratio, the loan life coverage ratio (LLCR), the project life coverage ratio (PLCR) or other liquidity and solvency ratios

Return on assets, EBITDA margin or other profitability ratios Other financial indicators such as capex divided by depreciation Other indicators that may relate closely to the client's business, e.g. passenger load factor percentage for airlines (although these are often of only subordinate interest to the lenders)

Covenants are often a crucial component in the financial planning of a company for all parties involved. For usability reasons, a lot of banks will ask for dedicated covenant reports within a financial model, preferably with diagrams. You should take that into consideration when planning your model, as you can greatly increase your bank's (or client's) satisfaction by including just a few simple formulas and diagrams.
The Daily Mail City team explain the significance of the agreements businesses make with banks when they borrow large sums of money. What are banking covenants? The conditions imposed by banks when they lend large sums of money. Just as a building society might insist you have gainful employment before it renews your mortgage, so big City institutions want to ensure firms have the financial wherewithal to service and repay their debts. How do they work? Covenants can be quite general. They may stipulate, for instance, that a business maintains a level of profitability that allows it to comfortably meet the interest payments on the loan. However they can also be very specific - as the online poker firms are discovering to their peril. Surprise, surprise Indeed. Market leader PartyGaming has been caught out by the small print of its banking agreement. It is having to renegotiate its 266m overdraft after the US changed its laws to ban internet gaming (there was a specific clause in its agreement with the banks that covered this eventuality). Tiny rival World Gaming says it is technically in breach of its covenants for the same reason. And if they are broken? Banks can ask for their money back, or demand penalty interest payments. Breaching financial covenants is serious stuff and a sign a company is in deep financial trouble.