What is Debt Covenant?
Debt Covenants are limits imposed on loan agreements by lenders to constrain the borrower's actions (the debtor). In other words, these are agreements between a firm and its lenders that enable businesses to follow specific regulations established by the lenders.
Understanding Debt Covenant
Financial constraints and banking covenants are other names for them. Debt covenants are not utilized to impose an economic strain on the debtor. Instead, they are employed to coordinate the organization’s interests and resolve authority issues between administration (borrower) and debt holders.
Whenever a debt covenant is broken, the lender has a few options to choose from depending on the seriousness of the breach -
- Demanding consequence reimbursement
- Enhance the specified lending rate
- Raise the quantity of collateral
- Require full loan repayment immediately
- Dissolve the debt procedure
Types of Debt Covenants
- Affirmative/positive covenants
Affirmative covenants, often known as positive covenants, force the lender to undertake a specific activity - thus limiting the company's financial performance.
- Restrictive/negative covenants
Positive covenants require the lender to execute certain acts, so negative covenants limit what the borrower may do; hence, they are also known as restrictive covenants.
- Financial covenants
Financial covenants are enforced to guarantee that the borrower retains a specified revenue growth and financial health level.
Practical Example
Lender x loans a firm $10 million. The lender lends at an average interest rate of 8%, depending on the firm's risk factors. Because there are no covenants, the firm can borrow $15 million from another lender right away (lender c).
Lender x would impose a debt limitation in this circumstance. Depending on the firm's risk level, they determined a lending rate of 8%. If the corporation borrows extra cash from other lenders, the credit will become a riskier prospect. As a result, the firm is more likely to fail on loan repayment to lender x.
In Sentences
- Some popular measures that lenders employ as debt covenants include interest coverage, fixed charge coverage, tangible net worth, and dividend payout ratio.