Among the many contract and reporting requirements managed by franchise owners, financial covenants – also known as loan covenants – may require review and additional action in 2011.

A new article on our website, Negotiating Fair Financial Covenants, looks at the impact of upcoming regulatory changes on existing financial covenants as the U.S. Financial Accounting Standards Board and the International Accounting Standards Board collaborate to bring their respective reporting standards into closer alignment this year.

Financial covenants establish benchmark metrics that can ensure a company stays healthy and help lenders mitigate risk. Examples of affirmative financial covenants can include a minimum current ratio, minimum net working capital, and minimum net worth. Common negative financial covenants include a maximum debt/worth ratio, maximum total debt, and other metrics.

Progressive convergence between the two boards’ standards may result in changes in asset and liability classifications. While there is no actual change in liquidity or overall business health, the classification changes can alter covenant ratios and result in a company no longer being in compliance, thereby causing a technical breach. In most cases, issues of this nature can be resolved by going to the bank as soon as the new covenant-related positions are recognized rather than waiting until statements are due. A comprehensive pro forma presentation to the bank provides a meaningful comparison of previous reporting positions to updated reporting positions and sets the stage for a request to modify the covenant appropriately.  

The article looks at a variety of covenant-related areas including preparing for negotiations, understanding the lender’s perspective, as well as reviewing and proactively managing your covenant positions.

It is important to stay ahead of the curve on all covenant issues in today’s tight credit environment. Failure to do so can place an organization at significant risk, while taking time to assess your requirements, prepare thoroughly, and engage in constructive discussions increases the likelihood of positive financial covenant outcomes.

Arthur F. Rothberg is the Managing Director of CFO Edge, a Los Angeles-based group of seasoned chief financial officers who engage with Southern California CEOs and CFOs to provide outsourced CFO services that address strategic planning, business management, and day-to-day financial operations challenges. 

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