The Importance of Financial Covenants in Elevated Interest Environments │ Canada

Many companies and business owners will have given special consideration to a wide range of factors recently, as they receive their year-end financial statements for the year ending 31 December 2022 and must now share them with their lenders in order to satisfy the latter’s financial reporting obligations. Key to these reports and forecasts should be the careful analysis of any financial covenants built into debt agreements, especially in light of the elevated interest environment in Canada.

Given that Canadian interest rates remain high, now is the perfect time to start focusing on financial covenants. Neglecting to subject covenants to the necessary attention, scrutiny and testing can mean that borrowers may, at best, be unaware of any potential future pitfalls – and, at worst, put themselves and their company entirely at risk.

Without delving too much into their inner workings, financial covenants can be included in loans by lenders to set certain conditions and guarantees that the borrower must adhere to – with the aim of protecting the lender’s investment and providing assurance that the borrower will stay on track for full repayment of the loan.

There is no standard set of financial covenants in any given debt agreement. Covenants can vary wildly, depending on a number of factors, such as the loan’s size or risk. However, in most instances, financial covenants are related to the borrower’s financial performance and act as a safety valve for the benefit of the lender by ensuring that the borrower remains on course to repay the loan.

As Canada’s central bank (the Bank of Canada) continues to grapple with rising inflation, interest rates remain high – meaning that the cost and potential risk of borrowing increases along with inflation. This is especially true for individuals and businesses with variable interest rate loans tied to these elevated interest rates. Fixed interest rate loans, while not tracking an underlying benchmark or index, are also likely to be trickier and more expensive during such times.

Broadly speaking, the impact of higher interest rates across the board – nationally and internationally – has been severe. The Canadian Imperial Bank of Commerce (CIBC) was recently reported to have USD52 billion-worth of variable-rate mortgages on its books, for example, with monthly payments that were not covering interest. In times like these, lenders pay increased attention to the financial covenants involved in debt agreements – both prior to and during the loan period – in an attempt to reduce their own exposure and help their borrowers keep up with repayments.

It is worth noting that, in the majority of debt agreements, financial covenants will allow a lender to examine a company’s financial statements regularly and ensure the borrower is sticking to the financial metrics that have been agreed upon. These metrics often include EBITDA, debt-to-equity and debt service coverage ratios.

Depending on what level of reporting has been agreed upon, financial covenants can also convey to the lender an assessment of risk. Have a company’s financials begun to approach any thresholds or metrics, as laid out in the debt covenants? How does the borrower’s cash flow look? Has the company management changed unexpectedly? Has discretionary spending increased? Even though the borrower may not necessarily be in breach of any covenants, a lender may ask these questions – and more – during its review of a loan’s financial covenants in order to decide how much risk the borrower represents.

Additional consideration should also be given to concessions that a borrower may need to make – such as reducing discretionary distributions to the business’ shareholders – to ensure the business has increased cash reserves.

In times of higher interest rates, lender aversion to such risks is similarly elevated, so care should be taken. In dire circumstances (especially in the case of a default), lenders may even decide to call in a loan if they have enough cause for concern.

As such, closer testing of the company’s financials against the loan’s covenants may reveal potential paths that the borrower can take – for example, reducing spending or avoiding internal restructuring – to improve the picture they paint and put lenders at ease. Among other advantages, this can help business owners remain attractive as a borrower and pay dividends further down the line should they plan to potentially take on more debt at some point (ie, for future growth or acquisitions).

Regardless of when it is necessary to provide the lender with the required information, there is never a bad time for borrowers to get better acquainted with their credit agreements and any related financial covenants. In a world in which no two banks are alike, doing so could mean the difference between being aware of everything that must be done to keep lenders happy and potentially disastrous breaches of a loan’s financial covenants.