Collaterals and Covenants

Covenants

Financial covenants are standards for the financial strength and performance of the borrower that serve as protections for both the bank and the borrower. Many a times, banks unilaterally set the covenants through negotiation and with the mutual agreement between the bank and the borrower.

Banks use a number of different financial covenants, some defined according to generally accepted accounting procedures and some defined in simpler, more basic terms. Financial covenants, regardless of the bases of their calculation, are intended to protect the bank and the borrower. The basic covenants, calculated on the simpler formulas as follows:

Tangible Net Worth (TNW)

TNW = stated net worth (NW) – (accounts and notes receivable from the borrower’s owners, officers or directors + goodwill + any other intangible assets, such as capitalized expenses) + subordinated debt

Leverage or Debt to TNW (D/TNW)

D/TNW = (total debt – subordinated debt) ÷ TNW

Current Ratio (CR)

CR = (current assets – intangibilized accounts and notes receivable) ÷ (current liabilities – current portion of subordinated debt)

Interest Coverage Ratio (ICR)

ICR = earnings before interest, taxes, depreciation, and amortization (EBITDA) ÷ interest expense

Debt Service Coverage Ratio (DSCR)

DSCR = EBITDA ÷ (interest expense + [current portion of long-term debt, including capital leases (CPLTD) – current portion of subordinated debt])

Fixed Change Coverage (FCC)

FCC = (Net profit + interest expense + lease expense + depreciation + amortization) (Interest expense + lease expense + CPLTD)

When covenants are properly put in place, they can protect the bank against a borrower’s deteriorating financial performance and condition. They should provide protection against borrower’s default.

Collaterals

When a loan is given, property or other assets are used as backing in case the borrower is unable to repay the amount. If the borrower cannot make the promised loan payments, the lender can then seize the collateral to compensate the losses. Financial institutions require collateral for mortgages and other secured loans, including foreclosure, non-recourse loans, and repossession. As collateral offers security in case the borrower fails to pay back the loan, loans that are secured by collateral typically have lower interest rates than unsecured loans. A lender’s entitlement to the borrower’s collateral is called a ‘lien.’ The collateral can be equal to, less, or greater than the value of the loan. This depends on many factors, including credit score, income, and how liquid the asset is.

Types of Collateral

Applicants can pledge various types of securities of value, including real estate, vehicles, inventory, stocks and bonds, and equipment. Tangible properties include machinery and equipment, fixtures, annuities, art, jewellery, etc. Intangible properties include investment funding, chattel paper, and payment rights.

The collateral required depends on the loan type and amount. Financial institutions that offer non-recourse loans accept:

• stocks,
• real estate,
• jewellery

Companies that apply for commercial loans can offer:

• marketing securities,
• natural reserves,
• real estates, and
• other assets.

Some businesses use personal assets such as land and residential properties to secure financing. Companies that apply for a large loan may offer estate such as:

• warehouses,
• office buildings,
• hotels, and
• shopping centers.

Natural commodities like coal, gas, and oil are also used for long-term loans and before launching large-scale projects. Corporations often use machinery and factory equipment when applying for large loans. Certificates of deposit, treasury certificates, bonds, and stocks are used as collateral because they have high liquidity. The amount of the loan offered depends on the value of the security.

Most firms, be it a limited partnership, public liability company, or sole proprietorship, apply for a commercial loan. Collateral is a method to prove to banks that the company is a viable borrower. When making the loan offer, financial firms look at equity contributions, assets, revenues, credit history, and the company’s balance sheets. A bank will establish collateral even if the company has a good credit rating.

Banks and Collateral

When valuation of collateral takes place, banks take a conservative approach with the assets to be pledged. This is because they will be using these assets to alleviate the loss caused in case of default. The fair market value of the asset is considered instead of the original price paid for it.

Companies and individual borrowers can use two types of collateral:

• assets pledged
• property owned

It is a favourable situation when the borrower has ownership of the property put on collateral. Banks also recognize different pieces of equipment and real estate, including second homes, motorcycles, trucks, and watercraft. In addition to vehicles, home, bond or stock certificates, etc., applicants can pledge collectibles and valuables, insurance policies, cash and savings accounts, and future payments.

Benefits of collateral to secure financing

• Secured loans have a lower interest rate and a longer repayment period than unsecured debt.
• It presents less risk to the financial institutions in the case of default as they can repossess the property or asset pledged as collateral.
• When there is unsecured debt, banks offer loans based on the applicant’s creditworthiness.
• Secured loans are easier to qualify for and even borrowers with a poor or imperfect credit score may be eligible.
• The borrower can repay the loan at any time and save on interest payments.