Debt Covenants

Definition of Debt Covenants

Debt Covenants which are also known as loan covenants or financial covenants, are defined as the agreements entered in between the borrower who are generally the creditors, and the lenders, who are generally large businesses and which includes the rules and regulations incorporated in it by the lenders, and the creditors have to follow or operate within those rules and regulations and treat them as a necessary condition for getting any commercial loans.

Explanation

In the financial market, many a time, there come situations where borrowers and lenders get into conflicts due to the confusion of the rules or the regulations that are accepted generally. So, the Debt covenant is the specialized and customized contracts between the borrower and the lender. The lenders decide rules and regulations regarding the loan and their prepayments, and borrowers have to operate within those rules to avoid any conflict between them.

Purpose of Debt Covenants

The main purpose of the debt covenants is to provide protection to the large business units that are engaged in the distribution of loans to the borrowers. As explained above, the borrowers have to operate within the lenders levy conditions; lenders get the idea of any creditor whose ability to repay the loan is impaired, and it highlights it as a “red flag”.

If borrowers are considered, the Debt covenants provide the opportunity to the borrowers to get the loans at very low borrowing costs. As the creditors have to agree to the conditions imposed by the lenders in providing the loans, the lenders lower their rate of interest and borrowing costs to the borrowers.

How Does Debt Covenant Work?

In Debt Covenant, the content of the agreement, i.e. the rules and the regulations for the loan, are decided by the lender, and the borrower has to operate within those rules and regulations. With this, the lender gets the safety against the repayment of the loan and gets the red flags on the inability of the borrower.

Also, as the borrower agrees to the conditions of the lenders regarding the repayment, the lender also get willing to reduce the interest cost of the loan, and thus the total borrowing cost get reduced, and thus it benefits the borrower.

Example of Debt Covenants

There are basically two types of Debt covenants: Positive and Negative.

Below are the examples of positive Debt Covenants:

• Some companies maintain life insurance policies on key employees to get protected against the loss of any managerial or other key personnel.
• Some repayment of loans requires the conditions of payment of all income tax and other tax compliances on time.

The examples of negative Debt Covenants are:

• Some lenders require the borrower to make changes in the ownership to approve the loans. So, if the borrowers want to make any changes in the business ownership structure, he has to take the lenders’ approval for the same.

How Debt Covenant Benefit the Borrower and Lender?

In Debt Covenant, the content of the agreement, i.e. the rules and the regulations for the loan, are decided by the lender, and the borrower has to operate within those rules and regulations. With this, the lender gets the safety against the repayment of the loan and gets the red flags on the inability of the borrower.

Also, as the borrower agrees to the conditions of the lenders regarding the repayment, the lender also get willing to reduce the interest cost of the loan, and thus the total borrowing cost get reduced, and thus it benefits the borrower.

Violation of Debt Covenant

The violation of the debt covenant results in the legal breach of contract between the borrower and the lender. There can be many violations of such a breach which can result in the following:

• The lender may increase the interest rate of the loan.
• It can lead to the termination of the agreement.
• It can attract penalties payments.
• It can result in an increase in the collateral amount.
• It can result in the demand for the immediate repayment of the loan and acceleration of the loan.

List of Debt Covenant

The below is the list of Debt Covenant:

• Interest Coverage ratio
• Debt-to-Equity Ratio
• Tangible Net worth
• Dividend Payout Ratio
• Debt payments to earnings before interest, taxes, Depreciation and Amortization (EBITDA)
• Current Ratio

Uses of Debt Covenant

The uses of debt covenant are different for the borrowers and lenders. The lenders use the debt covenant as the protection against the risk of non-repayment of the loan’s loan as the conditions and the rules in the debt covenant agreement are incorporated by the lender, and the borrower has to follow those rules for getting a loan.

The borrower uses the debt covenant as the source of the fund at low borrowing cost. As the borrower agreed to act according to the conditions and the rules by the lender, the lender generally lowers the interest rate on loan, which results in low borrowing cost. Hence, Debt Covenant results in the healthy flow of funds in the financial market, protecting both the borrowers and the lenders.

Benefits of Debt Covenant

Benefits of debt covenant are:

• The Debt Covenant provides a healthy flow of funds in the financial market. The borrowers and the lenders of the funds undergo the fund’s exchange, and it created the opportunity for the fund flow within the market.
• As the lenders decide the rules and conditions in the agreement, the lenders get protection against the default of repayment by the borrower.
• Also, as the borrower agrees to the conditions of the loan agreement, the lender also get willing to decrease the interest rate of the loan, thus results in the benefit of low borrowing cost for the borrower.

Conclusion – Debt Covenants

As the lenders decide the rules and the conditions in the debt covenant, the debt covenant does not put any burden on the borrowers. Rather it provides the opportunity to the borrowers to acquire the loans at low borrowing cost along with the proper alignment of the interest rate. Hence, the Debt covenant is an effective way of the flow of funds within the financial market.

Recommended Articles

This is a guide to Debt Covenants. Here we also discuss the definition and how does debt covenant work? Along with uses and benefits. You may also have a look at the following articles to learn more –

1. Debt to Equity Ratio
2. Equity Ratio
3. Investment Banking vs Private Equity
4. Interpretation of Debt to Equity Ratio