The Risk of Violating Debt Covenants
Originally published on June 21, 2022
Updated on November 20th, 2024
Healthcare practices have faced unexpected economic challenges in recent years. The instability has made it tough for some providers with loans to honor their lending agreements. But the consequences of failure to meet debt covenants or defaulting can be dire as they put future borrowing ability in jeopardy — or if they do secure a loan, it might be at a much higher interest rate.
The fact is, a bank’s authority over a loan doesn’t end with approval. Lenders often impose conditions that the borrower must meet throughout the life of the loan. These conditions, called debt covenants or loan covenants, are included in the lending agreement and can specify actions to be carried out or thresholds to maintain.
Understanding debt covenants is a key to helping you avoid violating them. Here’s a guide to get you started.
Why Do Lenders Use Debt Covenants?
The point of debt covenants is to protect lenders from excessive financial loss. If a debt covenant is violated by the borrower, the lender is usually able to call the loan due before subsequent months of unpaid installments accumulate or the borrower defaults.
You’ll generally see a few types of common financial covenants in a loan contract:
Affirmative Covenants
Also known as positive covenants, these require the borrower to do something specific to maintain the loan. This could include (but is not limited to):
- Supplying the lender with regular financial statements
- Maintaining proper books
- Having a certain level of insurance policy coverage in effect
Affirmative covenants are meant to keep the borrower in good financial condition, thereby increasing the chances they’ll pay off the loan successfully.
Negative Covenants
Negative debt covenants (also known as restrictive covenants) make borrowers avoid activities that could negatively impact their credit rating or ability to make payments. For example, lenders commonly require a minimum debt ratio (your total debt compared to your total assets), a days-cash-on-hand ratio (having enough cash accessible to last a set number of days) or limits on distributions to owners.
Incurrence Covenants
Negative and affirmative covenants are collectively called maintenance covenants because they make sure you maintain certain financial standards. Incurrence covenants, however, are a bit different. These prevent lenders from taking action until a specific financial ratio is breached. Incurrence covenants take effect when a predetermined triggering event occurs, such as taking on additional debt, making large investments or paying dividends.
Unlike maintenance covenants (which focus on action after your financial scenario takes a hit), incurrence covenants focus on preventing actions that could lead to deterioration in the borrower’s financial condition. As a result, they’re not as universally applicable as positive or negative covenants.
Consequences of Debt Covenant Violations
If you don’t meet your debt covenants, lenders can take any number of actions. They might require you to bring in a financial advisor to monitor your affairs. They could call the loan due before you miss (or are even late on) a payment.
Additionally, your credit or bond rating could be downgraded. This makes it more difficult for you to secure good loan terms, or get a loan at all, in the future.
Are You in Jeopardy of Violations?
Ideally, you’re paying attention to your finances and will know whether you’re in jeopardy of violating debt covenants. But there are other, more subtle indicators that you could be headed for trouble. For example, if you’ve got low patient volume, that means less money is coming into the practice.
You might also be experiencing staffing shortages, inoperable medical equipment or supply chain disruptions. These keep you from having the personnel, equipment and materials needed to care for your patients. And in the case of staffing shortages, practices relying on personnel services companies to fill those gaps are facing even higher payroll costs.
The bottom line: If your practice is losing money for these (or other) reasons, it means you’re less able to make loan payments. That puts you at greater risk of debt covenant violations — and in turn, ruining your credit rating.
How to Avoid Violating Debt Covenants
To avoid violating debt covenants, your medical practice can take several proactive steps to maintain a healthy financial situation.
Understand the Covenants
Thoroughly review your lending agreements and make sure you understand the debt covenants in every loan contract you have. Ensure all stakeholders are aware of the financial and operational requirements. You can also enlist the help of an attorney to make sure these covenants are standard and fair.
Engage in Regular Monitoring
Implement a system for routine monitoring of your financial metrics and performance. This can involve monthly or quarterly reviews to ensure compliance with all debt covenants. This could also include periodic internal audits to check financial statements, cash flow projections and other relevant documents against the covenant requirements.
Establish an Early Warning System
Set up alerts or thresholds within your financial management system to notify you when you are approaching the limits of your loan covenants. This allows you to take corrective action before a violation occurs.
Maintain Clear Communication
Establish open lines of communication with your lenders. Notify them proactively if you anticipate any issues or questions about your debt obligations, and work together to find solutions.
Engage in Financial Planning
Use strategic financial planning and budgeting tactics like forecasting cash flows, managing expenses and ensuring you maintain the required financial ratios.
Maintain Adequate Documentation
Keep detailed records of all financial transactions and decisions. Proper documentation can provide clarity and evidence of compliance if questions arise.
Establish an Emergency Fund
Maintain an emergency fund to cover unexpected expenses. This can help you avoid breaching your debt agreement due to sudden financial shortfalls.
Regular Training
Provide regular training to your financial and managerial staff on covenant compliance. Ensuring everyone is informed and vigilant can prevent accidental violations.
Hire Professional Help
Consider working with a healthcare CPA who understands the business side of your practice and how debt covenants impact you. They’ll help you make sure your accounting practices are sound and your processes are efficient. They can also perform a revenue cycle enhancement study to make sure you’re not leaving uncollected money on the table.
Getting a loan is tough as it is; the last thing you want to do is make it more difficult by not meeting debt or lease obligations. So make sure you’re aware of and understand your debt covenants, and ask your CPA for help if you’re concerned about your ability to honor them.
All content provided in this article is for informational purposes only. Matters discussed in this article are subject to change. For up-to-date information on this subject please contact a James Moore professional. James Moore will not be held responsible for any claim, loss, damage or inconvenience caused as a result of any information within these pages or any information accessed through this site.
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