Borrowers who breach their loan covenants could be putting their business in jeopardy, says Chris Lane, a partner at accountancy firm Kingston Smith.
I run a small family hotel. Last year I took out a loan to finance the refurbishment of the guest rooms and to make some improvements to the bar and dining areas, which I have agreed to pay back over a five-year period. I've not yet defaulted on my instalments but I am struggling financially. I was recently advised by a friend to re-read the small print of my loan agreement as a breach could result in the bank calling in the loan. Can the banks actually do this?
All borrowers should be aware that a breach of your loan covenants could have drastic consequences, such as your lender calling in the entire loan or at least charging a penal rate of interest.
Moreover, a breach may also have direct consequences for your statutory accounts, as the loan will need to be recategorised as a current liability on your balance sheet rather than a long-term liability given that it can be immediately recalled. This will affect the liquidity position of your business and may even mean that you are showing a net current liabilities position, which will alarm suppliers and others interested in your accounts.
The accounting rules do not allow for any discretion. So, where a loan covenant has been breached and then rectified after the balance sheet date, the classification of the loan as a current liability cannot be changed retrospectively - even if the lender has decided that it will not be calling in the loan. However, an additional disclosure in the accounts stating that the breach has been corrected may help to alleviate concerns.
You should make sure that you fully understand and monitor all the loan covenants that apply to your borrowing. In these difficult times, lenders are tightening up their procedures and monitoring covenants more carefully, so you cannot afford to ignore the small print.
The reclassification of a long-term loan could result in your balance sheet looking very different and raise questions about whether your business is viable as a going concern. This may require additional disclosure in your financial statements, which could cause suppliers and other interested parties to raise questions about their ongoing relationships with your business.
If you think a potential covenant breach is likely, you will need to consider what options you have to prevent it from occurring.
In extreme situations, you could consider extending your year-end so that any breach is rectified before the new balance sheet date.
- Be aware of all the covenants that apply to your borrowing.
- Speak to your lender in advance of any breach to find a solution to prevent it arising.
- Discuss any breach or potential breach with your advisers before the balance sheet date to form a strategy to disclose or correct it.
The economic downturn means that tighter lending criteria and closer monitoring of loan covenants are now the order of the day. It is therefore essential that borrowers are aware of the terms and conditions of their loans and discuss any breach or potential breach with their lenders and advisers at the earliest opportunity. Burying your head in the sand could mean grave consequences for your business and is not an option.
Chris Lane, Kingston Smith LLP
020 7566 email@example.com