What Is a Debt Covenant?
Debt covenants are agreements between banks and borrowers that dictate the way a company manages its finances while indebted to the bank. These covenants are tested on a regular basis during the term of the debt. Violations can result in stiff penalties, including the bank declaring the debtor in default.
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Types of Debt Covenants
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There are several different types of debt covenants. The most common is known as the Debt Service Coverage Ratio (DSCR). This ratio determines the amount of income you receive to service your debt. Typically banks will require a greater than one-to-one ratio. This means you must have more than one dollar in income for every dollar of debt. This covenant can be calculated pre- or post-distributions. Other types of debt covenants include "interest coverage," "debt-to-tangible net worth" and "senior debt-to-tangible net worth." Each covenant will be defined in the documentation.
Documentation
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A debt covenant is typically listed on two documents. It will first appear in the commitment letter issued upon approval of the credit. At closing, it is listed in the loan agreement. Covenants will be outlined in two sections: "affirmative covenants" (actions you can and should perform) and "negative covenants" (actions you can't perform). Debt covenants are usually located in "negative covenants." The terms used will be defined in accordance with generally accepted accounting principles (GAAP). The document will also detail the ratio you have to maintain, how the ratio is calculated, when the covenant will be tested and when to provide updated financials to allow for the testing. It will also state the penalties for covenant violation.
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Testing
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The loan agreement will detail the testing period and the ratio you must maintain. Banks typically test covenants upon receipt of the prior fiscal year end's financials. For example, a covenant for 2010 will be tested when the bank receives the borrower's 2010 tax returns, usually in April of 2011. When the financials are received, the bank will spread them. They will analyze the balance sheet and income statement and calculate the ratios to verify compliance with the covenant.
Violation
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If a covenant is violated, the bank may impose a penalty. These penalties can range from pre-arranged fees to calling default on your loan. The penalty will be outlined in the loan agreement. A borrower will have the opportunity to review this agreement prior to closing. If a borrower knows they are going to fail to meet a covenant, they should inform the bank immediately. A willingness to work with the bank and provide compensation such as deposits or additional collateral may circumvent the penalties.
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