Understanding Debt Covenants and How They Affect Your Nonprofit Organization

By Michael Trapp, CPA, Director

Understanding and meeting debt covenants related to new or existing debt is essential for a not-for-profit organization that holds long-term debt. Debt covenants are requirements imposed by a lender to verify the borrower’s financial stability. If the debt covenants cannot be regularly achieved, the debt may become callable by the lender, affecting the organization’s ability to secure future funding.

Be Aware of Your Debt Covenants and What Questions to Ask

Review your debt agreement and highlight any debt covenants. Common debt covenants can include:

  • an agreement to file audited and/or unaudited financial statements within a certain period after year-end,
  • a requirement to maintain a specified minimum amount of certain liquid assets, or
  • a debt service coverage ratio that must be maintained during the loan period.

Other debt covenants may require borrowers to maintain ratios related to operations, such as minimum enrollment or census totals over a given year. Debt covenants may indicate they be met on a quarterly or semi-annual basis, requiring constant monitoring throughout the year.

There are important questions organizations should ask to fully understand the debt covenants listed in the lending agreement and ensure they can be fulfilled, including:

  • Has the organization regularly completed the annual close and audit of the financial statements within the required timeframe, and will it be able to file them with the lender on time?
  • How should the calculation of the debt service coverage ratio be completed? Would the lender be able to provide a worksheet to help calculate the ratio?
  • Has the organization met the liquidity covenant or other operation ratios in the past, and are there any planned (or unplanned) changes in future operating budgets that may affect these covenants?

The above list includes just a few examples of possible debt covenants; it’s critical to review your debt agreements to ensure understanding of each one. Ask your lender for any templates that may help track the debt covenants for your organization. Then, review them and check the formulas entered to verify that they adequately support the calculation required per the debt agreement in place.

Over the last several years, not-for-profit organizations have been the recipients of funding from numerous government programs, which have helped offset any negative change in net assets due to COVID-19. Entering 2024, many of these programs have ended or are in the process of ending and will no longer be available as an additional source of income. The funding from these government programs may have helped achieve debt covenants in the past. Accurate forecasting will help determine if there are any issues with meeting debt covenant requirements in the future. Getting ahead of any possible default is critical for every not-for-profit organization.

The Importance of Understanding Debt Covenants

It is critically important to understand debt covenants already in place if your organization is considering entering into a new debt agreement or how changes in the activities of the organization or new regulations may affect the debt covenants going forward. Understanding the debt covenants will allow your organization to possibly avoid violating them and having to go through the arduous process of obtaining a waiver from the lender due to a violation. In the event of a violation, speak to your lender right away to alert them and begin the process of obtaining a waiver.

If you are unable to obtain a waiver, this could significantly change your organization’s financial statements for the year ended in which the violation occurred. The debt would be considered callable by the lender and would be shown as a current liability. In addition, disclosure of the condition in the notes to the financial statements would be required.

Effect of ASC 842, Leases and PPP

One area of potential concern for organizations with existing debt covenants is the adoption of Accounting Standard Codification 842, Leases (ASC 842). With the implementation of ASC 842, liabilities related to future payments of most leases are reported on the financial statements. The lease obligations under ASC 842 are shown as short- and long-term liabilities on the statement of financial position. If there is a debt covenant requirement for maintaining a ratio of current assets to current liabilities (current ratio) or for maintaining a ratio of total debt obligations to net assets (debt to equity ratio), the inclusion of lease liabilities under ASC 842 could result in failure to meet either or both these ratios.

Depending on how your organization accounted for the receipt of Paycheck Protection Program (PPP) funding, either as a loan or a refundable advance, or the interpretation and application of such funding into debt covenant calculations by the lender, the PPP funding your organization received could adversely affect certain existing debt covenants. Check with your lender to see how the PPP funding should be treated in debt covenant calculations.

Contact Us

If you have any questions about your debt covenants, please reach out to us. We welcome the opportunity to review the debt agreements with you and discuss how they may affect your organization. Contact your client engagement team or:

Michael Trapp, CPA
Not-for-Profit Services | 914.341.7640

Mark J. Piszko, CPA, CGMA
Not-for-Profit Services | 646.449.6316

John Cosgrove
Not-for-Profit Services | 914.381.8900