Business Financing Insights An Explanation of Financial Covenants and How They Affect a Business
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Feb 8, 2024 Alex Fallow, Executive Vice President and Chief Credit Officer at Celtic Capital, breaks down financial covenants and their role in lending. He defines covenant types and explains why banks use them. He covers key ratios like interest coverage and debt-to-worth, contrasts bank vs asset-based lender flexibility, and outlines consequences when covenants are breached.
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Why Lenders Use Financial Covenants
- Financial covenants let lenders monitor and control a borrower's financial trajectory to manage credit risk.
- Alex Fallow explains lenders use ratios like interest coverage and debt to tangible net worth to gauge cash flow and solvency.
Interest Coverage Shows If You Can Afford Interest
- Interest coverage ratio measures EBITDA versus interest cost to confirm sufficient free cash flow for interest payments.
- Lenders commonly require an interest coverage of roughly 1.25x or higher to satisfy this covenant.
Debt To Tangible Net Worth Thresholds
- Debt to tangible net worth compares outstanding debt to equity after removing intangibles like goodwill.
- Banks often expect debt to tangible net worth around 4:1 or 5:1, with asset-based lenders sometimes permitting higher leverage.