A covenant is a promise that restricts or impairs the ability of one party to act in some way. When a company raises debt, it is usually subject to conditions, restrictions, and terms known as debt (or financial) covenants.
The purpose of debt covenants is to protect creditors by ensuring that borrowers act responsibly and make payments on time. By imposing strict conditions on borrowers’ activities, they limit their freedom to operate.
The nature of these covenants varies widely but usually includes principal payments, interest rate changes, levels of financial leverage, working capital requirements, material contracts, mergers & acquisitions activity, and limitations on distributions.
Understanding Debt Covenants
Lenders take on a calculated risk when they provide debt capital to businesses. Each potential borrower has a unique inherent business risk. When lenders offer loans, they use debt covenants to manage the risk they assume.
Debt Covenants are guidelines imposed on borrowing agreements by lenders to limit the borrower’s conduct. To ensure businesses use debt financing properly, they must agree to adhere to specific lender-mandated standards.
Although many businesses see financial covenants as too economically restrictive, the objective isn’t to put the company under any more stress. Debt Covenants bring the interests of the lender and borrower into alignment.
For the lender, these provisions provide safeguards by restricting activities that might significantly impact or raise the debt provider’s risk.
Covenants protect lenders’ financial interests and reassure them. For borrowers, these provisions provide guidelines for running the company’s operations. They define the extent of the borrower’s actions and enhance communication regarding borrowing activities between lender and business.
When determining which covenants they wish to impose upon a borrower, lenders will consider various factors. Some covenants are customized to meet this or that particular need or requirement. For example, restriction on dividend payments is common in publicly traded companies. In contrast, we can often see the limitation on asset disposals in businesses with extensive assets such as real estate holdings and manufacturing operations.
Covenants vary from one industry sector to another and, in some instances, within an industry group. The focus, however, is always clear: manage risk, enhance communication, and build trust.
Positive (or affirmative) covenants state what the borrower must do, requiring specific actions. For example, suppose debt providers place a positive debt covenant on borrowing agreements requiring borrowers to maintain certain levels of net worth. In that case, they will intend to protect further against the erosion of capital and any resultant loss or impairment of creditworthiness.
Some examples of positive covenants can be:
- Achieve threshold on specific financial ratios
- Ensure facilities are in good working order
- Regularly maintain high-cost equipment
- Produce audited financial statements
- Apply particular accounting and reporting frameworks
Negative debt covenants restrict activities that might jeopardize lender interests, such as dividend payments and asset sale restrictions. If lenders place a negative covenant on borrowing agreements that prohibits business activities that might impair capital or the borrower’s creditworthiness, they will intend to protect financial interests.
Some examples of activities that covenants can restrict:
- Pay dividends above a certain threshold
- Sell specific key assets
- Borrow more debt
- Enter into specific contractual obligations
- Engage in M&A activities
Routine Covenant Violations
A routine covenant violation is just that – routine. For example, it occurs when a business falls short of meeting scheduled interest payments or debt repayments. Common violations are not unusual, and lenders understand that they may occur for many reasons beyond the control of management, such as changes in macroeconomic conditions or any number of other factors. Lenders consider these developments before deciding on appropriate actions to take should this happen.
The lender can issue a waiver for broken covenants. Those are usually for a specific period when the borrower can remedy the breach.
Recurring Default (Event of Default)
If a borrower continues to break covenants, a more strict set of actions may be taken. The most severe penalty a lender can impose is to declare an event of default against the borrower. At this point, lenders have accelerated recourse options they can exercise against the entire loan balance or seek remedies for past-due amounts before proceeding further.
In the event of default, the lender has the right to call the entire principal amount of the debt plus any accrued interest.
Calculating Debt Covenants
Although there are many financial covenants a lender can impose as part of the loan agreement, there are some that you are almost sure to come across.
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Debt-to-Equity (D/E) Ratio
It is a leverage ratio that calculates the weight of total debt and financial liabilities against the total shareholder’s equity. This ratio highlights how a company’s capital structure is tilted toward debt or equity financing.
The D/E ratio is commonly used to evaluate how a company is taking on debt to finance its assets.
Some analysts calculate the ratio by putting Total Liabilities in the numerator. At the same time, some prefer to keep it more in line with the Gearing Ratio and only look at Total Debt. In some cases, you can also include material future fixed payments.
In a general case, we would use the following simplified formula:
A high ratio value is often associated with increased risk as it indicates the company has been financing its growth predominantly with debt.
Analysts generally consider 1 or below to be an excellent D/E ratio. Anything above 2 is a red flag for the company being over-leveraged.
A negative ratio is generally considered an indicator that the company is going under. On the other hand, if the debt-to-equity ratio is negative, equity is negative, and the company has more liabilities than assets. Lenders would consider such borrowers extremely risky.
It is important to remember that the D/E ratio is difficult to compare across industry groups where ideal amounts of debt will vary.
Interest Coverage Ratio (ICR)
Also known as Times Interest Earned (TIE), this financial ratio measures how likely the company will make interest payments on time each period. A business that doesn’t generate enough operating profits to cover its interest expense poses a heightened credit risk to lenders.
The Interest Coverage Ratio helps us evaluate the riskiness of lending capital to the borrower.
If the company has more outstanding debt and higher interest charges, it will have a lower Interest Coverage ratio. Therefore, a lower ratio translates to a higher risk of default, as fewer operating profits are available to meet interest payments. It also means the business is more vulnerable to volatile interest rates.
A higher ratio shows more robust financial health and indicates the company can meet interest obligations. However, it could also mean the company is underleveraged to the point that it’s missing opportunities to grow operations through debt.
An Interest Coverage ratio below 1 shows poor financial health, which means the company already can’t cover its interest payments. Analysts usually consider a ratio of 1 to 3 as a red flag, and anything above 3 is generally good.
The ratio works best for determining short-term financial health. However, a declining ratio can be an early indicator of potential future issues when analyzed over time.
Net Debt to EBITDA Ratio
This covenant measures the company’s financial leverage and ability to pay off its debt. It indicates how long the company needs to operate at its current performance level to pay off all outstanding debt. This is an essential indicator that lenders use to determine if the borrower’s cash flow can handle scheduled payments or if future defaults are likely.
Analysts generally prefer a low Debt to EBITDA ratio, indicating no excessive indebtedness. This means the company should be able to repay its debt obligations.
A high ratio means the company is over-leveraged. Generally, lenders would consider anything above 4 or 5 as a red flag, and it would cause concerns for the ability of the borrower to settle its debt in the future.
In terms of debt covenants, lenders would usually set a maximum Debt to EBITDA ratio and require borrowers to remain below this level.
It’s important to remember that ratios vary significantly between industries, as they differ in capital requirements.
Debt covenants are provisions within financial agreements such as loans or credit lines between lenders and borrowers that restrict certain activities like dividends and asset sales to protect lenders’ interests and maintain their risk exposure at acceptable levels.
A good understanding of debt covenants will help you choose the right lender. You’ll want a loan agreement that provides your business with adequate support to meet its capital and operating requirements. A covenant-lite loan, for example, maybe more suitable than one with many restrictive covenants if your current needs indicate otherwise.
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