Financial Covenants

What is Financial covenants?

Financial covenants are conditions or promises in a loan agreement that require the borrower to maintain specific financial performance levels. They serve as early warning signals for lenders and are designed to protect them from excessive risk by monitoring the borrower’s financial health.

These covenants are commonly used in corporate loans, bonds, and credit agreements.

Purpose of Financial Covenants

The main objectives of financial covenants are to:

• Ensure the borrower stays financially stable.
• Prevent the borrower from taking excessive risks.
• Give lenders the ability to intervene if the borrower's performance declines.
• Maintain a certain level of trust and discipline between the lender and borrower.

Types of Financial Covenants

1. Maintenance Covenants

These require the borrower to maintain specific financial ratios continuously or at regular reporting periods.

Examples:

• Debt-to-Equity Ratio: Limits how much debt a company can have relative to its equity.
• Interest Coverage Ratio: Ensures the borrower can meet interest payments from earnings.
• Current Ratio: Checks if the company has enough current assets to cover current liabilities.

2. Incurrence Covenants

These are triggered only when the borrower takes a specific action, like taking on new debt or making a large dividend payment.

Examples:

• Limiting Additional Borrowing: Borrower must meet certain ratios before taking on new debt.
• Restrictions on Asset Sales: Limits selling major assets without lender approval.

Consequences of Breaching a Covenant

If a borrower fails to meet a financial covenant, it is considered a default, which can lead to:

• Increased interest rates (penalty rates)
• Early repayment of the loan
• Renegotiation of loan terms
• Legal action by the lender

In some cases, lenders may waive the breach if it's minor or if the borrower can provide a satisfactory explanation.

Why Financial Covenants Matter?

For lenders, they act as protective tools that help minimize credit risk.

For borrowers, understanding and managing covenants is crucial to avoid default and maintain access to future credit.