Updated July 14, 2023
Definition of Debt Covenants
Debt Covenants which are also known as loan covenants or financial covenants, are defined as the agreements entered in between the borrower, who are generally the creditors, and the lenders, who are generally large businesses, and which include the rules and regulations incorporated in it by the lenders.
The creditors must follow or operate within those rules and regulations and treat them as necessary for getting commercial loans.
Explanation
In the financial market, often, there come situations where borrowers and lenders get into conflicts due to the confusion of the rules or the generally accepted regulations. So, the Debt covenant is the specialized and customized contract between the borrower and the lender. The lenders decide rules and regulations regarding the loan and their prepayments, and borrowers must operate within those rules to avoid conflict between them.
Purpose of Debt Covenants
The main purpose of the debt covenants is to protect the large business units engaged in the distribution of loans to the borrowers. As explained above, the borrowers have to operate within the lender’s levy conditions; lenders get the idea of any creditor whose ability to repay the loan impairs, and it highlights it as a “red flag”.
Considering borrowers, including debt covenants, allows them to obtain loans at very low borrowing costs. As the creditors have to agree to the conditions imposed by the lenders in providing the loans, the lenders lower their rate of interest and borrowing costs to the borrowers.
How Does Debt Covenant Work?
In a Debt Covenant, the agreement’s content, i.e., the rules and the regulations for the loan, decides by the lender, and the borrower has to operate within those rules and regulations. With this, the lender gets the safety against loan repayment and red flags on the borrower’s inability.
Also, as the borrower agrees to the conditions of the lenders regarding the repayment, the lender gets willing to reduce the loan’s interest cost. Thus the total borrowing cost gets reduced, thus benefiting the borrower.
Example of Debt Covenants
There are two types of Debt covenants: Positive and Negative.
Below are examples of positive Debt Covenants:
- Some companies maintain life insurance policies on key employees to protect themselves against the loss of any managerial or other key personnel.
- Some repayment of loans requires the conditions of payment of all income tax and other tax compliances on time.
Examples of negative Debt Covenants are:
- Some lenders require the borrower to change ownership to approve the loans. So, if the borrowers want to make any changes in the business ownership structure, he has to take the lenders’ approval for the same.
How Does Debt Covenant Benefit the Borrower and Lender?
In a Debt Covenant, the agreement’s content, i.e., the rules and the regulations for the loan, is decided by the lender, and the borrower has to operate within those rules and regulations. With this, the lender gets the safety against loan repayment and red flags on the borrower’s inability.
Also, as the borrower agrees to the conditions of the lenders regarding the repayment, the lender gets willing to reduce the loan’s interest cost. As a result, the borrower benefits from reducing total borrowing costs.
Violation of Debt Covenant
The debt covenant violation results in a legal breach of contract between the borrower and the lender. There can be many violations of such a breach which can result in the following:
- It can lead to the termination of the agreement.
- It can attract penalty payments.
- The lender may increase the interest rate of the loan.
- It can increase the collateral amount.
- It can result in the demand for the immediate repayment of the loan and acceleration.
List of Debt Covenant
Below is the list of Debt Covenant:
- Interest Coverage ratio
- Debt-to-Equity Ratio
- Tangible Net worth
- Dividend Payout Ratio
- Debt payments to earnings before interest, taxes, Depreciation, and Amortization (EBITDA)
- Current Ratio
Uses of Debt Covenant
The uses of debt covenants are different for borrowers and lenders. The lenders use the debt covenant as protection against the risk of non-repayment of the loan’s loan as the conditions and the rules in the debt covenant agreement are incorporated by the lender, and the borrower has to follow those rules to get a loan.
The borrower uses the debt covenant as the source of the fund at low borrowing cost. As the borrower agrees to act according to the lender’s conditions and rules, the lender generally lowers the interest rate on the loan, resulting in low borrowing costs. Hence, the Debt Covenant results in a healthy flow of funds in the financial market, protecting both the borrowers and the lenders.
Benefits of Debt Covenant
The benefits of debt covenant are:
- The Debt Covenant provides a healthy flow of funds in the financial market. The funds’ borrowers and lenders undergo the fund’s exchange, creating the opportunity for the fund flow within the market.
- By determining the rules and conditions in the agreement, lenders secure protection against borrower default in repayment.
- Also, as the borrower agrees to the conditions of the loan agreement, the lender gets willing to decrease the loan’s interest rate, thus resulting in the benefit of low borrowing costs for the borrower.
Conclusion – Debt Covenants
As the lenders decide the rules and the conditions in the debt covenant, the debt covenant does not burden the borrowers. Rather it provides the opportunity for the borrowers to acquire the loans at low borrowing cost along with the proper alignment of the interest rate. Hence, the Debt covenant is an effective way to flow funds within the financial market.
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