Debt Covenant

Debt Covenant

The restrictions imposed by the lenders on the borrowers are known as debt covenant. It is a formal agreement or promises made between parties like creditors, vendors, suppliers, shareholders, investors, and a company that announces the limits for financial ratios which a debtor must refrain from breaching. Debt covenants are the restrictions that a borrower agrees to which are set by the lending institutions.

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Purpose of Debt Covenants:

Debt Covenants are issued to ease the borrower and not to burden them. It is used to align the interests of the principal and agent. It serves as a tool to solve the agency problems between the management and debt holders. It protects the lender by prohibiting certain actions of a borrower. Alternatively, it also protects the borrower by reducing the cost of borrowing.

Types of Debt Covenants:

There are 2 types of Debt Covenants:

  1. Positive: It states what a borrower should do to remain on good terms with the lender. In short, these are the things that a borrower should follow to ensure that he gets the loan.
  2. Negative: It states the things which a borrower cannot do. These are the actions that the lender prohibits the borrower from doing.

Example of Debt Covenants:

Let’s assume that AB & Co. has taken debt from a bank. The bank has offered the company a $2 million loan with a condition that until the company pays off the bank the principal plus a 10% interest, the company will be unable to take any additional loan from the market.

This restriction imposed by the bank on AB & Co. is called a bond covenant. But what would be the reason that the bank would do such a thing? Let’s analyze it.

  1. Firstly, the bank would do the checking before lending the amount to AB & Co.
  2. If the bank finds that AB & Co. doesn’t have a good risk profile, lending them a big sum would be risky too for the bank. In this case, if the company goes out and also borrows a million here and another million there and goes bankrupt, the bank will not get back its money.
  3. Thinking about the future risk, the bank may put restrictions on the company from borrowing any additional loan until the loan of the bank is being paid off in full.

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Final thoughts:

Debt covenants also known as banking covenants or financial covenants is a formal contract or agreement between the company and its lenders that the operations of the company will be as per certain rules set by the lenders. Basically, it does not aim to burden the borrower, but in order to get their money back, the lenders do bind them with a few terms and conditions. In simple terms, it protects the interests of both lenders and borrowers.

Author: Urvi Surti

About the Author:

Urvi is a commerce graduate and has a keen interest in Finance. She has completed her Chartered Wealth Management (CWM) from the American Academy of Financial Management and is currently pursuing a career in Financial Risk Management (FRM).

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