Financial Covenants

What are Financial Covenants?

Author: Astrid Dsouza
Astrid Dsouza
Astrid Dsouza
I graduated with a Bachelor of Commerce in Accounting and Finance from Curtin University, Dubai. I was a member of the Vice-Chancellors List for three semesters. Additionally, I am the Undergraduate Valedictorian of the graduating class of 2023. I am currently pursuing a Master of Economics degree at the University of Sydney. I have worked as a Financial Research Analyst Intern at the Wall Street Oasis. I also interned at the Transnational Academic Group, Dubai, as a Financial Analyst Intern.
Reviewed By: Rohan Arora
Rohan Arora
Rohan Arora
Investment Banking | Private Equity

Mr. Arora is an experienced private equity investment professional, with experience working across multiple markets. Rohan has a focus in particular on consumer and business services transactions and operational growth. Rohan has also worked at Evercore, where he also spent time in private equity advisory.

Rohan holds a BA (Hons., Scholar) in Economics and Management from Oxford University.

Last Updated:November 4, 2023

What are Financial Covenants?

Financial covenants are the lender's contractual provisions restricting the borrower's activities. 

Credit refers to an agreement wherein a borrower accepts money from a lender in exchange for the commitment to return the amount, with additional interest, at a later period. Lenders are generally creditors, investors, banks, or other financial institutions. Borrowers are usually companies.

When extending a loan to a debtor, creditors take a credit risk. Credit risk is the probability that the borrower would default on their interest and principal payments. Therefore, creditor protection is a priority issue, and regulations have implemented safeguards to ensure it. 

To mitigate the severity of the loss, creditors should also conduct background checks before issuing credit. 

Credit risk analysis is the procedure lenders undertake to assess a borrower's creditworthiness. The borrower should use quantitative and qualitative data to understand the borrower's repayment capabilities.

Another way to ensure and secure the contractual payment obligation is by adding a covenant. 

Covenants are restrictive agreements or promises that form a contract between two parties. For example, a deal is made between two parties whereby one agrees to do or not do some activity toward the other.

Key Takeaways

  • Financial covenants are the restrictions on the borrower's activities enforced by the contractual provisions in a lending contract. 
  • It is used to protect the lender's interest in debt contracts. In addition, it provides security from the probability that the borrower cannot meet their financial obligations. 
  • There are three types of covenants: positive, negative, and financial covenants. 
  • Financial covenants are obligatory undertakings by the borrower to maintain a particular level of financial performance or financial ratios. For example, it could be maintenance or incurrence covenants. 
  • When the borrower fails to meet a covenant, the contract is breached. The severity of the consequences depends on the borrower.

Understanding Financial Covenants

Covenants, in finance, are the limitations to the borrowers’ activities. Covenants are always present in debt contracts like loans or bond issues. The borrower must follow the conditions of the agreement to ensure that the contract is valid. 

These covenants typically compel the borrower to maintain financial performance. For example, a loan contract can state that the company should be able to maintain a minimum leverage or interest coverage ratio. Covenants are also indicative of management quality. 

Note

Covenants also indicate the company's overall financial strength as they apply to the subsidiaries of parent companies. 

The lender could answer the following questions by imposing covenants in debt contracts.

  • Could the borrower easily repay the principal and interest from their earnings?
  • What is the borrower's leverage ratio, and how much should it be maintained?
  • Is the current ratio indicating that the company is liquid and solvent?
  • Can the interest be covered with the current earnings?

Compliance with the covenants can be measured periodically or on a specific date. 

What is the purpose of financial covenants?

The primary reason covenants were introduced was to protect the lender and reduce the probability of default. In addition, it covers the lenders' interest, thereby reducing the agency problem. 

The agency problem, in this case, is the disagreements between the borrowing company’s managers and the banks (lenders). Furthermore, due to the lending agreements, the borrower and lender would have a close and transparent relationship. 

Lenders can observe the financial health of the borrower using these covenants. By regularly calculating the borrowers’ financial ratios, the lender could gain insights into their financial aspects and early warning signals for any foreseeable financial difficulties. 

The borrower can also save themselves from becoming insolvent. For example, when the borrower is compelled to maintain minimum financial ratios, the managers invest in growth opportunities to fulfill their contractual obligations. Thus, the borrower could remain solvent. 

Note

Covenants can also restrict the borrower from undertaking excessive debt or indulging in activities that could create a downside risk to the lender.

Types of Covenants in Debt Contracts

Debt contracts could have the following covenants.

1. Positive / Affirmative Covenant 

These state the activities that the borrower must be doing. If a borrower violates such a covenant, it usually results in the cancellation of the loan agreement and the immediate demand for the principal and interest. For example, 

  • Must promptly provide the lender with their audited financial statements.
  • They should maintain their books correctly and adhere to the applicable accounting standards.
  • A certain financial ratio, like a minimum interest coverage ratio, should be maintained.  
  • The borrower should ensure that the business runs efficiently and their assets perform well. 

2. Negative Covenant 

It states the activities the borrower must not be doing. The borrower must refrain from such activities mentioned in the loan terms. Lenders usually acknowledge this covenant to safeguard the borrowers’ repayment ability. For example: 

  • The borrower must not undertake an excessive debt or issue additional debt.
  • Capital assets should not be sold without authorization.
  • Dividends cannot be issued to the shareholders. 

3. Financial Covenant 

These state that the borrower must sustain certain financial performance ratios. When the company can comply with the set ratios, they indicate it is solvent, reducing the credit risk. 

The balances usually mentioned are interest coverage, leverage, gearing, and current ratio. Other indicators are the company's tangible net worth and dividend payout ratio.

A financial covenant can be further divided into maintenance and incurrence covenants.

1. Maintenance covenants 

These specify that the company must be able to maintain a certain level of operational metrics for the contract to be valid. 

For example, the company must maintain an interest coverage ratio at the industry average. The industry average Interest coverage ratio is 35.52x for the technology sector in Q4 2022. 

2. Incurrence covenants 

These restrict the borrower's actions which would significantly affect its financial performance. For example, the company cannot incur further debt, issue dividends or new securities, or merge or acquire other businesses.  

Significance of Financial Covenants

Financial covenants are obligatory undertakings by the borrower to maintain a particular level of financial performance or financial ratios. It provides leverage to the debtor during the borrower's financial difficulties, mitigating the credit risk.

The financial covenant differs from the other covenants (affirmative and negative) as it only considers a numerical metric. A company’s financial health and stability are determined by calculating ratios. This is particularly important for a lender to assess throughout a loan term. 

A lender monitors this covenant closely as it could indicate early warning signs of financial difficulty. 

The credit ratios and operating performance standards have to be met by a borrower. Therefore, an unwanted balance change due to financial problems could lead to a breach of the debt contract. 

Types of Financial Covenant Metrics 

The most common financial covenants mentioned by lenders are

1. Interest Coverage Ratio 

This covenant measures the firm’s ability to repay the debt interest from the Earnings Before Interest and Taxes (EBIT). 

Interest Coverage Ratio = EBIT / Interest Expense 

2. Debt-to-equity Ratio 

This covenant measures the debt amount in the company’s financial structure relative to its equity. 

Debt to Equity Ratio = Debt / Shareholders Equity

3. Leverage Ratio 

This covenant measures the leverage, i.e., the amount of debt compared to the firm's total capital.

Leverage Ratio = Debt / (Debt + Shareholders Equity) 

4. Tangible Net Worth 

This covenant measures the value of the company's tangible assets after deducting the total liabilities and intangible assets. It represents the amount the company could gain if all its assets were sold and debts were reimbursed. 

Tangible Net Worth = Total Assets - Intangible Assets - Total Liabilities

The intangible assets include goodwill, patents, and other intellectual properties owned by the firm. The tangible assets include land, property, cash and equivalents, inventory, etc. 

5. Current Ratio

This covenant measures the company's liquidity. It measures the ability to meet its short-term obligations using short-term assets.

Current Ratio = Current Assets / Current Liabilities

6. Cash Flow Coverage Ratio

This covenant measures the ability of the company's cash flows to meet the interest expenses. 

Cash Flow Coverage Ratio = (Operating Cash Flow - Capital Expenditures) / Interest Expense

Note

Capital expenditure is the amount a business spends to acquire, maintain, or upgrade its capital assets like plant, property, and equipment (PPE). 

Other financial measures lenders use that are not calculated using ratios include maintaining a minimum level of cash flow, EBITDA, or EBIT. EBITDA is the Earnings Before Interest, Taxes, Depreciation, and Amortization. 

Lenders could also impose a financial covenant based on the firm's operations. These could limit operating expenses, capital expenditure transactions, asset sales, and ownership change. 

It can also mention that the credit rating has to be maintained at a certain level. Credit rating agencies like Moodys and Fitch issue credit ratings to companies. They assess the creditworthiness of a company.

What If The Company Cannot Meet Their Requirements?

The contract is breached when the borrower cannot meet one or more of the covenants given in the loan contract. The magnitude of consequences the borrower will face depends on the lender and the extent to which the contract was breached.

For example, the consequences would be limited if the company cannot maintain a ratio for one period. 

On the contrary, the effects would be higher if the company defaulted on the agreement by repeatedly not keeping the credit ratios at a certain level. It could indicate solvency issues and the risk of the lender increases. 

In the event of a default, the lender can demand full payment of the principal and interest or take additional legal action by involving the Court. 

Borrowing corporations could also use their assets as security, such as capital assets, receivables, or inventory. Defaulting on the loan may cause the bank to demand a portion of the collateral the company cannot repay.

Instead of taking legal action, the lender can charge a higher interest rate with an extended borrowing period. 

Advantages of Financial Covenants

Let us first begin by analyzing the advantages of financial covenants:

1. Reduced Credit Risk for the Lender

The lenders have a sense of security that the borrower would repay their dues. In addition, the risk associated with the lending agreement reduces as the lender has a safety net in the form of covenants. 

2. Agency Problems Are Reduced

The lender is not put in a position of uncertainty. The lender has complete control over the contract terms and the borrower, bridging the agency gap.

3. Borrower’s Financial Performance Stability

The borrower should maintain a certain level of financial performance. This urges the borrower to have financial stability and helps them to be solvent throughout the loan term. 

4. Benefit for the Borrower's Interest Rate

Debt agreements with a covenant provision attract a lower interest rate for the borrower. Although the maintenance provision seems stringent, a loan with a higher interest rate is much more troublesome for the borrower. 

Disadvantages of Financial Covenants

On the contrary, the disadvantages of debt covenants are 

1. Financial Risks Are Lowered, But Not Eradicated

Although the lender's financial risk has reduced considerably due to covenants, other unprecedented financial risks still exist. For example, the onset of the COVID-19 pandemic was not anticipated and led to defaults in loan agreements. 

2. Limited Financial Freedom

The borrower faces reduced financial freedom. As incurrence covenants restrict certain activities that affect economic performance, the managers cannot invest in other growth opportunities. As a result, the managers are sometimes put in a position where the preference of lenders precedes the shareholders or investors. 

3. Limited Operational Freedom

The borrower also faces limited and rigid operational freedom. The management is restricted from being able to diversify their operations as it could adversely affect a ratio.

4. Window dressing

The borrower could sometimes face difficulty maintaining different kinds of financial covenants simultaneously. It could lead to the borrower fabricating the ratios to showcase better performance to safeguard themselves from a loan breach.

Financial Covenants FAQs

Researched and authored by Astrid Dsouza | LinkedIn

Reviewed and edited by Parul GuptaLinkedIn

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