Lambert Chapman LLP's Paul Short cautions "Beware the Bank Covenant"

A corporate banker recently told us that any interest rate with a 2 at the front will be rare indeed in the future.  He also indicated that lending will be based on LIBOR (London Interbank Offered Rate) rather than bank base rate, so that banks are not caught out again if there is an abnormal gap between the two.

I recalled my clients who had taken out finance early in 2008.  The overdraft was at 2.0% over bank base and the medium to long term loan was at 1.5% above bank base.  They agonised at the time with bank base rate at a higher percentage but now it is looking like very good business, particularly if one takes tax relief at higher rate into account.

What is clear is that the banks will be looking to renegotiate as soon as any review date is reached.  Indeed the more impatient banks will try and accelerate this event and a customer failing to meet a banking covenant in their agreement will provide just such an opportunity.

One of my clients was actually aware that one banking covenant required the submission of annual financial statements within 6 months of the year end.  It had never been taken up before but the client made damned sure they met the covenant this year to retain their 2.0% loan finance facility.

In my experience, most business people do not know what their banking covenants are.  A banking covenant is a condition which one is required to fulfil for the retention of bank finance.  Most people sign the finance agreement and then put their copy of the agreement in the right hand drawer without ever looking at it again.  They can be blissfully unaware of the commitments that they have given in order to have this finance.

Typical banking covenants might be:

1. To provide the banker with periodic management accounts by a certain date after that period end.
2. To provide year end financial statements within so many months of the year end.
3. To maintain interest rate cover (i.e. profit before tax and interest divided by interest) at a determined level.
4. To ensure that debtors cover borrowing by an agreed multiple.
5. Restrictions on borrowing unless with bank permission.
6. A required level of profitability.

The covenants can be onerous.  What should clients do?

1. Make sure they have a copy of the agreement.
2. Make sure that they know all the covenants that have been imposed upon them.
3. Make sure that the business’s management information systems are robust enough to deliver the financial information to the bank.
4. Make sure that the management information is generated as quickly as possible so that there is early warning if a banking covenant is at risk.

Nick Forsyth has focused on producing good month end management information and his pack can be adapted to individual circumstances so that the key information relating to bank covenants is highlighted and then reviewed.  The danger for any client would be to be advised that the bank are reviewing the terms of the finance, when the client is totally unaware that there had been any breach of covenant.  The worst case could be that the bank seek to withdraw the finance, leaving the business to try and find replacement finance in a challenging lending environment.

We will be happy to look at any finance documentation, for our clients, to identify the covenants and then help to make sure that the systems are in place to ensure compliance. Please contact me in the first instance on 01376 326266.

Date:16 February 2010

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