New Roland Berger study on key financial indicators for bank loans: companies still have difficulty raising capital and find their scope for strategic action severely limited. Yet loans are rarely terminated where financial covenants are violated

• Banks now grant loans only where there is limited risk of default
• However, breaches of covenant rarely lead directly to loans being terminated
• Managers say that covenants severely limit their scope for action
• Companies foresee increasing problems raising capital in the future

With the economic and financial crisis in full swing, it is harder than ever for companies to secure loans. Banks will now only grant loans where there is limited risk of companies defaulting. Over the coming 6 to 12 months, most companies are expecting it to get even tougher to secure debt or equity. One way they can still access funds, however, is via creditor protection mechanisms such as financial covenants. These are the findings of a new study published by Roland Berger Strategy Consultants entitled "Financial covenants and corporate financing". It draws on the results of 500 interviews with the CFOs of leading companies.

Dr. Sascha Haghani, Partner at Roland Berger Strategy Consultants and head of the Corporate Finance Practice Group: "As the financial and economic crisis continues apace, corporate financing is more important than ever in safeguarding companies' continued existence. Today, banks are prepared to offer companies loans only where their risk of defaulting is limited or can be reduced." Financial covenants – arrangements between banks and companies under which companies agree to meet certain financial ratios as a condition of borrowing – allow banks to exert influence over the borrower and thereby limit the risk of them defaulting on the loan. For instance, financial covenants can require the borrower to maintain specific equity, debt, earnings or liquidity levels over the period of the loan. Today, unlike three years ago, almost every loan agreement contains general covenants of this type. These are the findings of a new study by Roland Berger Strategy Consultants entitled "Financial covenants and corporate financing." The study draws on the results of more than 500 interviews with the CFOs of leading companies from various sectors of industry carried out in the first half of 2009.

Information requirements in loan agreements

Two types of general covenants are distinguished: positive and negative covenants. Some 96% of the companies interviewed in the course of the research said that they used positive covenants within the framework of loan agreements. Negative covenants were used by just 76% of companies. For those companies using positive covenants, far and away the largest proportion of covenants – some 98% – involve information requirements, followed by insurance requirements (51%). Some 76% of companies have financial covenants in their loan agreements. Of particular importance are financial covenants relating to the company's earnings (EBITDA) or cashflow, and hence its ongoing ability to service debt. Such covenants include conditions relating to EBITDA interest cover (found for 64% of companies that have financial covenants) and upper limits on annual investments or CAPEX limits (found for 31% of companies). Debt ratios, such as the leverage ratio (59% of companies) or debt/equity ratio (28%), also commonly feature in credit agreements.

Breaching covenants rarely leads to termination

According to the study, breaching a covenant rarely leads directly to loans being terminated, however. Lenders turn to other actions first. These can include charging the company a fee – a "covenant waiver fee" for example (20% of companies) – renegotiating the loan agreement and adjusting future financial covenants accordingly (18%) or forcing the company to take counteraction (14%) such as cost-reduction programs or selling off unprofitable parts of the business. Some 55% of the companies surveyed had no experience of breaches of covenant and their negative consequences.

Covenants limit companies' scope for action

Many managers feel that their scope for strategic action is limited by covenants, however. In the survey, 52% of those interviewed felt that their freedom was severely restricted. Notably, only 14% of companies felt that their specific market and industry situation was given enough prominence when agreeing covenants. Co-author of the report, Dr. Matthias Holzamer: "German companies currently find themselves in a difficult situation. They are experiencing two crises at once: an economic crisis and a financial crisis."

No surprise then that companies take a bleak view of the future. Over the coming 6 to 12 months, most of the companies in the survey are expecting it to become increasingly difficult to get hold of capital. The majority fear that banks will set even stricter criteria both for new loans (81% of companies "agreed" or "agreed strongly" with this view) and loan extensions (64% "agreed" or "agreed strongly"). Dr. Sascha Haghani again: "This clearly shows that the financing situation of many companies has taken a sharp turn for the worse. No improvements in capital procurement or liquidity are currently in sight."

Managers face growing challenges

The economic and financial crises have led to a strong increase in the challenges facing CFOs and CEOs. This is true both in terms of raising capital and with regard to how they manage their stakeholders (creditors and shareholders). In response, companies should investigate every potential avenue for improving their financing situation. In terms of equity, better cash and working capital management can be of help. Dr. Sascha Haghani: "In terms of borrowing, companies should consolidate their relationship with their principal bank. But they should also generally try to reduce their dependency on bank loans, and in the area of capital structure they should take a critical look at dividends and share buybacks."