Debt Covenants: Definition, Types, And How does it work?

Definition

Financial debts and loans tend to be highly common across all businesses today. As a result of this, it is highly important to note the fact that debt covenants mainly exist in the case of financial contracts, predominantly on grounds of ensuring that the receiver of the debt abides by the stated rules and regulations.

It is also imperative to consider the fact that debt covenants make sure that all aspects which have been mutually decided upon by both parties are included in the stated analysis.

Hence, debt covenants can simply be defined as agreements between the business and the creditors.

Under this agreement, the borrowing company is supposed to abide by certain laws and regulations, in order to be entitled to receive the loan. If those conditions are not met, the borrower is no longer lent the money by the lending party.

Types of Debt Covenants

Regardless of the fact that debt covenants are in practice in order to act as a safeguard to the lending party, they are important for the buyer too.

This is because it incentivizes them to perform in a certain manner, which pays off in the longer run. Generally, debt covenants can broadly be categorized into two broad categories, which are:

  • Positive Debt Covenants: As far as positive debt covenants are concerned, it can be seen that these are the type of debt covenants that are in place in order to ensure that the borrower acts in a certain manner, by ‘positively’ and actively working on those things. For example, the lender might keep a requirement that the borrower should maintain a certain threshold of working capital, and should not delay the interest payments associated with the debt payments. Positive debt covenants are simply to reinforce favorable and positive behavior for the company, in order for the loan to stay safe and secure.
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Using positive debt covenants, the lender can ensure that the money is safe, and the company does not default by not acting in a desirable manner. Therefore, these covenants are in place for the safety of the organization that has extended the loan. 

  • Negative Debt Covenants: Negative debt covenants, on the other hand, are clauses of the agreement between the lender and the borrower, which refrains the borrower to act in a certain manner. Negative debt covenants are in place to ensure that the borrowing party does NOT take a step that might increase the risk threshold. By signing the debt covenant with negative debt covenants, the borrowing party is supposed to avoid the mentioned clauses. Failure to do so might result in a penalty, or the debt being revoked altogether.

An example of negative debt covenants might be the instance of refraining the company to take on additional loans during the mentioned time. For example, they might be barred to pay their loans and their balances. In the same manner, the borrower might be barred by the lender to sell equity, or any fixed asset if they are unable to make the periodic payments.

How do Debt Covenants work?

As mentioned earlier, Debt Covenants are important for both the borrower and the lender. They normally include financial thresholds and targets that need to be maintained by the borrowing party.

In this regard, it can be seen that debt covenants are in place after stringent research that is undertaken by the lender, about the buyer.

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When the borrower approaches the lender, the lender undertakes a risk assessment. This is to gauge the likelihood of the borrower to repay the relevant amount. This is an important aspect, based on which future arrangements are drawn.

During the risk assessment, the lender also requests the borrower to present with future financial forecasts they have prepared internally.

After a deep study about the company’s internal, as well as the external environment, the lender then comes up with certain covenants to minimize their risk. Those arrangements are drawn and then communicated with the borrower.

If the borrower agrees to the stated terms and conditions, then the debt is released, and then the borrower is expected to abide by them at all costs.

Between the time of the loan application, and the time when the finance is actually released, there might be a probationary period.

During this period, the company will be monitored on grounds like revenue, profitability, target fulfillment, and liquidity.

In order to assess if the company is performing well, the lender might state certain requirements that need to be met in terms of the aforementioned clauses.

In the case where these clauses are not met, the debt arrangement is revoked, and the company does not qualify. However, if the company meets all the targets, then the lender is supposed to release the finance, as agreed earlier.

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