Covenants are there by banks for good reason- they hold companies accountable for results and can serve as early warning signals. Before an interest or principal payment is missed, a covenant could be missed and action taken before more serious damage is done.

There are often several covenants, covering things like:

1. Operating results

2. Debt payment coverage

3. Leverage

4. Net worth

Banks will put in a number of covenants.  But if you are not careful, it could be too many.  You could be setting yourself up for covenant indigestion.

The more covenants you have, the more likely it is that one will get broken.  Sometimes, several indicators can be in the right direction, but one has gone the other way.  It is like a sports team that has won the game, even though they fell short in one area.  A football team may have outgained the opponent, controlled time of possession, had more first downs, but gave up one more turnover.

A sports team ultimately gets measured on one stat- did they win or did they lose.  If they came up short on one leading indicator, it is still OK.  They still won.

A company may not have that luxury.  It can be profitable for the year.  It can feel like it won the game of business that year.  But it better also hit 5 out of 5 covenants.  Miss one and it might not matter.

A client was just like that.  They had record cash flow.  They paid down bank debt and reduced their leverage.  Their net worth grew since they were profitable.  However, EBITDA was down since it was closely tied to sales in a tough economy.  Management made the right moves to preserve cash flow but there was just no way to meet the EBITDA level.

At worse, it can mean be putting out on the banking street- go find another bank.  At best, it can be open season to renegotiate- higher interest rates, points and legal and other fees.

It can often happen at the wrong time.  The time you trip that one covenant may also be the time that the banking market has dried up.  

The best time to fix this is before you sign on that new loan.  Fewer covenants are better for you.  More important, make sure the ones you do have are really important and are consistent.  Ask yourself, could you be doing very well as a business, yet tripping one of the covenants?  If so, should a different covenant be used in its place?  Should it be cut out all together?  Is the covenant OK to have, but does it just need to set at a different level?

Know what you are getting into.  Fight for less.  Fight for consistency.  Otherwise, you could be setting yourself up for covenant indigestion.  The price to cure the heartburn will be high- higher rates, higher points and higher fees.