How Debt Covenants Work

A covenant is a formal agreement found in contracts and today we will explore what a debt covenant is and how they are beneficial for borrowers. Covenants are often put in place by lenders to protect themselves from borrowers defaulting on their obligations due to financial actions detrimental to themselves or the business.

What Is a Debt Covenant?

Debt covenants are agreements between a business and creditor saying the company will operate based on the rules established by the lender as a condition for receiving a commercial loan.

The purpose of a debt covenant is to align the interests between the principal and agent and solve problems between the borrower and lenders. Debt restrictions protect the lender by not allowing certain actions by the borrowers that can impact or be of risk for the lender. The borrower benefits from reducing the cost of borrowing because lenders are willing to impose a lower interest rate for the debt.

Debt Covenant Examples

Depending on the lender, the state of your business, and the loan details, debt covenants come in many forms. The following are some examples financial covenants use in loan agreements:

  • Debt payments to Earnings Before Interest, Taxes, Depreciation and Amortization (EBITDA) – a ratio of 3:1 is a good for lenders, if it is less then borrowers could have problems meeting debt obligations.
  • Interest Coverage Ratio – this ratio should be a 3 or more for adequate coverage.
  • Debt-to-Equity Ratio – this ratio is the total debt to a company’s equity capital base. Depending on the industry you are in, high debt ratios are acceptable.
  • Debt-to-Total Assets Ratio – this ratio tells how much of a company’s assets are financed by creditors.
  • Tangible Net Worth – this is the net worth of the company that excludes intangible assets like patents, copyrights, and intellectual property.
  • Dividend Payout Ratio – the number of dividends paid to shareholders in relation to the company’s net income.
  • Current Ratio – businesses need sufficient liquidity to purchase supplies, pay vendors, and meet payroll.

Positive vs Negative Debt Covenants

Debt covenants are also referred to as loan covenants or financial covenants. There are two types of loan covenants, they are positive and negative.

Positive debt covenants state what the borrower must do such as:

  • Achieve a certain threshold in certain financial ratios
  • Ensure facilities and factories are in good condition
  • Perform regular maintenance of capital assets
  • Pay all property and income taxes on time
  • Maintain property insurance and liability insurance
  • Provide yearly audited financial statements

A negative covenant state what the borrower cannot do such as:

  • Sell certain assets
  • Borrow more debt
  • Pay cash dividends over a certain amount or predetermined threshold
  • Enter into certain agreements or leases
  • Make a change in ownership
  • Mergers and acquisitions

Violation of Debt Covenants

A debt covenant violation is a breach of contract and when this happens, the lender can do the following things:

  • Request an increase in the amount of collateral
  • Raise the interest rate
  • Impose penalty payments
  • End the loan agreement
  • Accelerate the loan and demand payment

If there is any reason that the borrower is unable to make the loan payments, they must meet with the lenders and ask for a waiver. Lenders will be more than willing to help out because they want borrowers to be successful so they can get the loan repaid and work with them again.

Why Companies May Avoid Debt Covenants

Debt covenants can be overly restrictive and there is a real possibility that a borrower will breach one unintentionally. As a business owner, you need think about what it would take to breach one of the covenants in the contract you are about to sign.

If breaching a debt covenant seems well within plausible imagination, the borrower should be wary. In a worst case scenario, an owner could make a single misstep that breaches a debt covenant and then lose control of their business unless they can pony up the full loan amount.

The Bottom Line

Debt covenants are put into place for lenders and borrowers to provide an indication that changes need to be made within the company or credit agreement that support both the success of the lender and borrower.