If the company is a good risk, only minimum limitations need be set. A poor risk, of course, is different. Its limitations should be greater than those of a stronger company.
Look now for a few moments at the kinds of limitations and restrictions which the lender may set. Knowing what they are can help you see how they affect your operations.
The limitations which you will usually run into when you borrow money are:
- Repayment terms.
- Pledging or the use of security.
- Periodic reporting.
A loan agreement, as you may already know, is a tailor-made document covering, or referring to, all the terms and conditions of the loan. With it, the lender does two things:
- Protects position as a creditor (keeps that position in as protected a state as it was on the date the loan was made) and
- Assures repayment according to the terms.
The lender reasons that the borrower's business should generate enough funds to repay the loan while taking care of other needs.
The lender considers that cash inflow should be great enough to do this without hurting the working capital of the borrower.
Covenants: Negative and Positive-
The actual restrictions in a loan agreement come under a section known as covenants. Negative covenants are things which the borrower may not do without prior approval from the lender.
Some examples are: further additions to the borrower's total debt, non-pledge to others of the borrower’s assets, and issuance of dividends in excess of the terms of the loan agreement.
On the other hand, positive covenants spell out things which the borrower must do. Some examples are:
- Maintenance of a minimum net working capital.
- Carrying of adequate insurance,
- Repaying the loan according to the terms of the agreement, and
- Supplying the lender with financial statements and reports.
Overall, however, loan agreements may be amended from time to time and exceptions made. Certain provisions may be waived from one year to the next with the consent of the lender.
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