Financial (Debt) Covenants

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What are Financial (Debt) Covenants?

Financial Covenants, also called Debt Covenants or Banking Covenants, are restrictions contained in lending agreements between a company and its creditors that the company must operate within certain limits. They are aimed at ameliorating a common agency problem: Shareholders (who appoint the management) may benefit from taking excessive risk, to the detriment of creditors.

Conditions in Financial Covenants

Debt covenants are intensively negotiated, as they require the borrower to maintain a certain financial status for the duration of the loan, and they set minimum standards for the borrowers future conduct and performance. The conditions included in debt covenants vary with the borrower's business characteristics, financial condition and loan duration.

Breach of a debt covenant usually allows creditors to demand immediate repayment. This rarely happens in practice because the debtor is usually not in a position to make an immediate repayment. A breach of covenants therefore normally leads to a renegotiation of the terms of debt. The new debt is then likely to contain worse terms than the one before. This means that if a company breaches, or is in danger of breaching, its debt covenants, not only does this indicate that the company is financially weak, but also that the problems are likely to become worse as lenders react.

Forms of Debt covenants. Types

Debt covenants can be differentiated into affirmative covenants and negative covenants:

• Affirmative Covenants: clauses in debt contracts that the borrower must maintain certain levels of Working Capital, Financial Leverage, or financial ratios (Gearing Ratio), adhere to and generally include using the loan for the agreed-upon purpose, fulfill certain financial and reporting requirements, adhering to laws, allowing the lender to inspect business assets and documents, as well as maintaining business records and business properties.
• Negative Covenants: clauses in debt contracts that limit or prohibit corporate actions (e.g. sale of assets, payment of dividends, mergers and acquisitions, limits on total indebtness and investment of funds) that could impair the position of creditors. These covenants tend to be more significant and even more intensively negotiated than affirmative covenants, as they place direct restrictions on the actions borrowers can take.

Benefits of Debt Covenants. Advantages

• For Creditors: Debt covenants benefit creditors by reducing default risk.
• For Borrowers: Lower cost of debt. The lower default risk generally translates into lower cost of debt, due to the fact that creditors are willing to offer loans at lower rates of interest.

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