Why Are Financial Covenants Important for the Long-Term Success of a Borrower-Lender Relationship?

With technological advancements in every field, the lending landscape may change over time. However, one thing will remain the same: the tried and tested usage of financial covenants to manage risk. Beneficial for both the borrowers and lenders, they are essential for the long-term success of a borrower-lender relationship. That is why many lenders use covenant analysis services to monitor their covenant performance and mitigate risk. 

Financial covenants are effective tools that bind the borrowers and the lenders together for their respective risk management during the relationship. Proper analysis helps draft the covenants with clarity and sufficient flexibility to safeguard and nurture the interests of both parties. Remember, analyzing the covenants is crucial not only for large corporates but also for small and medium sized businesses. Covenants are friends, not foes to both parties. 

Let us see how financial covenants help nurture the relationship between the borrower and the lender.

How Covenants Protect Both Parties

Financial covenants are beneficial for both the lenders and the borrowers. 

Protection to Lenders: Lenders use covenants to identify any changes in the loan-related risks. Covenants do not ensure loan repayment, but they help identify the borrower’s risk and performance changes. A loan’s success depends on the borrower’s effective use of the capital and timely loan repayment in full. Covenants help identify potential risks before they actually happen. Such risks may be associated with acquisitions, increased leverage, customer churn, reducing working capital, and extended sale cycles. By identifying these signs in time, lenders put a guardrail to ensure the safety of their loan against default. 

Transparency to Borrowers: With financial covenants, borrowers get complete transparency into what needs to be done to ensure successful results. When a borrower misses a payment or breaches a covenant, it does not automatically mean increased interest rate or loan default. On the contrary, it is the right time to have a meaningful conversation with the lender and find the best possible solution. Finding a mutually agreeable resolution is beneficial for both the borrower and the lender and improves their relationship.

Reduced Cost of Borrowing: Besides transparency, covenants also benefit the borrowers by lowering their cost of borrowing. Since covenants assure lenders of loan repayment with reduced risk, they feel more confident lending money to the borrowers at lower interest rates. 

Trust and Commitment: Once a lender wins a borrower with complete protection to their interests, in most cases, the borrower goes back to the same lender instead of exploring other options. The lender also wants to do business with the same borrower repeatedly rather than risking their money for new borrowers. This happens due to their trust in each other they build during the first loan term.

Safety with the Contractual Knot: The borrower and the lender are bound with a contractual agreement for short-term and long-term loan facilities. They support the loan document with security or guarantee. Good security strengthens the relationship between the borrower and the lender since the lender can enforce the security on-demand or on default. 

Financial Covenants for Long-Term Relationship 

As mentioned earlier, financial covenants are not meant for large corporates only but are equally important to small and medium sized businesses. Maintaining short or long-term loan capital is a 2-way responsibility of both the parties involved. Covenant analysis helps receive up-to-date and accurate financial information about a company. It helps a lender understand how the borrower is performing currently and where it is heading in the short or medium term.

When financial covenants are in place, both parties focus on their mutual interests to develop a long-term and strong relationship. Since there are different tiers of covenants, first level covenant breach does not mean default. Instead, it encourages both parties to negotiate and mutually understand each other’s requirements. Therefore, such understanding makes excellent sense to improve their relationship and build mutual trust.To make the best use of financial covenants, a regular covenant analysis is of the essence. Data-based analytical results help identify risks and take crucial decisions in time. Since covenants are meant to protect the interests of both parties, analyzing their performance and taking timely action is extremely important for the long-term success of a borrower-lender relationship. Get in touch with a covenant analysis solutions provider and nurture your relationship for long-term results.

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