Covenants: the promises in your loan

A covenant is a promise you make in your loan agreement. When the bank lent you money, it set some conditions. They're usually in the facility letter, under a heading like "financial undertakings" or "conditions". Many farmers sign and never look again, until a poor year.

The terms vary a lot between banks and between loans. Your own documents are what count, and a solicitor is the person to read them with you.

Three kinds

Financial covenants set a level your figures must stay above or below. Common ones are a minimum interest cover, a maximum LVR, a minimum debt service cover or a minimum equity ratio. They're usually tested once a year, from your financial statements.

Reporting covenants are promises to send information. Examples are annual statements within a set time after 30 June, a yearly budget, stock numbers or insurance certificates. These are the ones most often broken, usually because the accounts are late.

Review events let the bank review the facility if something happens. Examples are a fall in the value of the security or a change in who owns the business. They usually lead to questions and new terms rather than straight to enforcement.

Find yours

Get out your facility letter and list every covenant on one page: what it is, the level, and how often it's tested. Then work out where you sit today, and where you'd sit in a poor year. The gap between the two is your room.

What a breach can lead to

Breaking a covenant is called a breach. What follows depends on your agreement and your bank. It might be a letter and a waiver, a higher interest margin, new conditions such as monthly reporting or, in a serious case, a demand for repayment.

For small business customers, the Banking Code of Practice limits which defaults, other than missed payments, a bank can act on. It generally requires at least 30 days' notice. It also says the bank will only act on such a default if it's material, or likely to have a material effect. A solicitor can tell you how that applies to your loan.

Tell the bank first

If your forecast shows a covenant will be missed, tell the bank before the statements arrive. Bring the numbers, the reason and your plan, such as selling stock earlier or putting off a machinery purchase. A breach the bank hears about from you, with a plan, is a far easier conversation than one it finds on its own.

Our guide to farm loan covenants goes into more detail.