There are a number of typical loan covenants that are applied to businesses operating in the financial planning industry
In my discussions with advisers around the country there appears to be a common misunderstanding about the purpose of loan covenants. This also includes the reasons why banks put them in place for lending arrangements whereby the primary security and repayment source for the borrowings is the cash flows of the business.
So why are covenants important and why do banks require them?
Covenants, if set appropriately and monitored regularly by both the business and the bank, can be an effective tool in highlighting early warning signs of increasing risk, but also in demonstrating the effect of management decisions on the business cash flows.
Covenants are also important when the security offered to the bank has a relatively fluid and dynamic business value such as a financial planning business. This value needs to be able to be monitored and measured on a regular basis to assess the ongoing risk profile.
For business owners, being aware of movements in key ratios at an early stage allows them to address the concerns before they escalate, which will help preserve and build long term business value. In a financial planning practice, business value can diminish quickly if matters concerning diminishing revenues or increasing expenses are not highlighted and fixed at an early stage.
It is important to note that you can have either negative or positive covenants. A negative covenant limits or prohibits actions that the borrower may take without prior written consent of the bank, such as limitations on the amount of dividends a company may pay. A positive covenant specifies an action that the borrower agrees to take or a condition that they must abide by, such as providing periodic financial statements to the financier.
A few of the typical covenants that are applied to businesses operating in the financial planning industry include, but are not limited to:
Interest cover – defined as the ability of the business to meet its interest expense from the Earnings Before Interest and Tax (EBIT). Measured as dividing EBIT by total interest expense. This is applicable where interest only debt is proposed.
Note that the EBIT figure should always be “normalised” to include a nominal figure for principal/s remuneration. This figure can vary dependent on the size and complexity of the practice. This is also referred to EBITAPR, Earnings Before Interest and Tax After Principals Remuneration. Businesses should be targeting interest cover in excess of two times, which then supports the ability to amortise debts. If businesses are only achieving one times or less then there are no surplus earnings to put towards debt reduction and often additional funds are required to be injected into the business to meet its commitments. This position was not uncommon during the GFC.
Debt Service Cover – defined as the ability of the business to meet its principal and interest payments from EBIT. Measured as dividing EBIT by total principal and interest (P&I) payments. This is applicable where debts are on a P&I basis.
EBITAPR should also be used in this calculation. Businesses should be targeting debt service cover in excess of 1.50 times, which then illustrates an ability to meet all P&I commitments and also allows for other payments such as taxation.
Setting of a minimum recurring revenue figure by which it must not fall below. This is to protect the secondary position being the asset value and to ensure that the loan to value ratio does not increase beyond acceptable levels.
Reporting covenants requiring the provision of regular financial statements to assess business performance and measure against expectations.
For a financier, covenants, if managed and monitored effectively, can be an early warning sign where a deteriorating trend is evident. If a breach is found to have occurred, a “right of review” is triggered to determine the extent of the breach, which allows the client and the bank the opportunity to discuss the reasons behind the breach and if corrective actions are required to address the issue.
Covenants are designed to provide triggers that highlight potential problems well before the issues get to the point where they cannot be resolved and the business is left with little or no alternatives.
Take for example the events of the GFC and its resultant impacts on both new and recurring revenue streams. Few, if any, financial planning practices were completely immune to the effects of the GFC on their revenue streams and as a result breached a number of loan covenants.
It is critical for the financier in these instances to have an understanding of the impacts such an event has on businesses operating in the financial planning industry and acts appropriately in a collaborative manner.
At NAB, we take the opportunity to discuss the impacts on the business and also if there are any other flow on affects as a result such as taxation and superannuation guarantee arrears. It is best for business owners to be open and honest and discuss with their banker immediately a breach is determined. The bank genuinely wants to work with the business to get the best outcome for all parties.
As business owners it is important to understand the impact of management decisions when exploring appropriate gearing positions for the business. Gearing covenants are effective in providing ongoing measurements for this purpose and also assist with understanding effective gearing levels that achieve the required return on investment by the business principal/s.
You clearly expect a minimum overall longer term return for clients when creating investment strategies, it is therefore prudent to articulate the minimum return on your investment in the business that you expect and monitor this regularly.
In summary, your financier wants to understand your business and its drivers better. Covenants are an effective tool in providing an ongoing measurement around some key areas that then present an opportunity for the business owners and the bank to regularly discuss how the business is performing, both the not so good and the success stories.
