When taking a loan from a bank, the contract may or may not include special conditions named as covenants. Usually, when the loan taken is in a small amount and with minimal risks, the banks do not see the need to add any special covenants to conditions of the agreement. However, the bigger the amounts and risks go, the higher is the probability you will find covenants from the agreement.

Covenants are ratios the borrower’s financial statements have to meet. They are usually connected to the amount of assets, cash inflows, EBITDA (earnings before interest, tax, depreciation and amortization), net profit etc. Mind you that for every agreement those covenants are negotiated and agreed as reasonable and reachable. The bank just wants to make sure the borrower is able to fulfill its obligations and serve the loan.

With the inability to meet the covenants, the bank normally has the right to exercise immediate fulfillment of the agreement, namely calling the loan bank in full in a very short time period.

As such, in case there is a breach in those covenants, all liabilities connected with the agreement – principal and interest payments due – are to be classified as short term liabilities. The bank has the right to call back the loan in less than 12 months hence it’s not correct to show it as a long term liability.

So do watch out for those covenants and make sure all your liabilities are properly classified.