What are Bank Covenants and why are they necessary?

Dealers need to borrow cash to run their businesses, but not all loan types are the same.

Dealers need access to a ton of capital, and I mean a ton!

Think about it, no dealership is sitting on enough cash to fund their operations. Money will be needed for new and used vehicle inventory purchases, parts inventory purchases, building upgrades and leasehold improvements, not to mention the cash needed to pay employees and vendors every month. That’s a lot of cash! The relationships dealers have with their lenders are critical to their ongoing success.

Funds can be easily accessed when the right partnerships exist. That said, access to this capital isn’t free and is certainly not given based on a “gentleman’s handshake.”

Proper due diligence is always done by both parties before a lending agreement is ever reached. Most lending agreements incorporate covenants to ensure borrowers are financially sound and have the necessary liquidity to repay their debts. A covenant is a promise that a borrower makes to a lender to comply with certain conditions throughout the course of a loan. They go beyond simply paying back the money that was borrowed.

Funds can be easily accessed when the right partnerships exist. That said, access to this capital isn’t free and is certainly not given based on a “gentleman’s handshake.”

Loan covenants are broken down into 2 elements:

  • A “keep well clause” describes what companies will, or will not do, while the loan is outstanding. For example, it may require you to keep a certain management team in place, or, to remain a good-standing franchise dealer of a recognized OEM throughout the life of the loan;
  • A “financial clause” requires you to maintain certain levels on key financial ratios throughout the life of you loan. These are meant to give the lender a quick snap shot of your liquidity and borrowing positions at any point in time. 


Common types of covenants:

  • Debit-to-equity: This ratio is calculated by dividing total debt by total equity and is considered a primary measure of debt capacity. If your ratio is high relative to your peers, it is perceived to hinder your company’s ability to raise new debt if it’s needed to survive major economic downturns. That is, highly leveraged companies carry more risk of missing debt payments when revenues decline. In general, a company with less debt and more equity (i.e. low debt-to-equity) is viewed as a heathier organization than one on the opposite end of the spectrum;
  • Current Ratio: This ratio measures a dealer’s short-term liquidity, or, its ability to pays its bills that are currently coming due. It’s calculated by dividing current assets with current liabilities. Naturally, companies who own more than they owe are perceived to be healthier than those carrying more debt so you always want this ratio to be greater than one.   
  • Debt-Service-Coverage Ratio: This is a key measure of a company’s ability to repay its loans, make dividend payments, and take on more debt. It is commonly used to evaluate capacity to finance future growth and assess credit worthiness. It is calculated by dividing earnings before interest, taxes, depreciation and amortization by interest and principal payments. In other words, it shows how much earnings a company can generate for every dollar of interest and principal paid. While debt is a common component of every business’ balance sheet, it is critical to assess the manageability of that debt. The debt-service-coverage ratio is a classic metric to assess this exact concept.

What happens if you are in breach

A few possible consequences may occur if your dealership fails to meet its agreed upon covenants.

If the breach is minor, your lender will simply discuss the matter with you and help you develop a corrective action plan. For serious or reoccurring issues, lenders can recall their loan and end their relationship with you. It is important to note that lenders don’t want you to fail. In fact, they’ve loaned you money because they believed in you and want you to succeed in your entrepreneurial journey.

The key to any banking relationship is to have open channels of communication. If you find yourself in a situation where you are about to breach covenants, be proactive and talk to your bank about it right away — they’ll appreciate that more than you know. 

Keep covenants in mind when you’re making business decisions. Whether you are looking to acquire new equipment, buy an existing business or simply increasing your vehicle inventory floor plan line, these all have implications to your existing and future loan covenants.

Make your strategic decisions considering all aspects of your business, including but not limited to, future capital requirements and implications to current banking agreements.

Related Articles
Share via
Copy link