A financial covenant is a promise or agreement in an indenture, or any other formal debt agreement entered into by a borrowing party that are financial in nature. The borrowing party agrees to comply with the terms agreed upon in relation to a loan agreement. Such that certain activities will or will not be executed and that certain possible thresholds must be met. This type of arrangement may also be called a banking covenant.
The debt covenant restricts the actions of the borrower or debtor and is a source of protection for the lender or creditor. Other restrictions may include a limit on additional borrowings so as to not further deteriorate the credit quality of the borrower.
A major criticism of covenants is that by the creditor is imposing restrictions on how the debtor should conduct business, they are dictating company policy. As the debtor’s economic freedom of choice is restricted the lender becomes the de facto manager. This has potential to lead to great conflict and likely to harm the business. If this situation worsens, and company performance is affected it may increase the likelihood of a covenant being broken. If the debtor is unable to fulfil their obligations the whole loan may become due. This could ultimately lead to a sale of company assets initiating a vicious cycle of negative performance.
Excessive borrowing is one way target firms look to defend themselves against a hostile takeover. Traders should be aware of any significant covenant issues pertaining to the target firm before initiating a position.
The Use of a Bond Covenant
The restrictions and obligations placed upon the borrower and agreed upon in the terms of the loan fall into one of two categories.
Positive Covenants
An affirmative or positive covenant requires a borrower to perform specific actions. This may include supplying audited financial statements to the lender or the maintenance of proper accounting books. Violations may result in outright default although occasionally, loan contracts may provide the borrower with a grace period to rectify the violation.
Negative Covenants
Negative covenants restrict borrowers from certain indulging certain actions that have the potential to damage their credit rating or ability to repay existing debt. The most common forms of negative covenants are the maintenance of certain financial ratios such as the quick ratio (acid test ratio). Debt to earnings is also often used. The use of the EBITDA ratio is also common where earnings must be in a certain ratio to debt repayments
