Typical Debt Covenants

Banks and other lenders use debt covenants to mimize their risk.

Debt covenants are contractual restrictions or requirements that a lender places on a borrower when making a commercial loan. They are monitored throughout the loan term so the lender remains aware of a borrower's financial condition and can proactively address any potential problems the borrower may have with paying the loan back. There are several typical debt covenants lenders use to minimize their risk.

Types

Debt covenants can be categorized in several ways including affirmative or negative, and financial or non-financial. Affirmative covenants require something be done, while negative covenants restrict certain actions. Financial covenants allow lenders to place financial restrictions or requirements on a company, such as maintaining certain financial ratio levels, while non-financial covenants entail other requirements such as maintaining proper business insurance.

Affirmative and Negative Covenants

Affirmative covenants typically include requirements that a well-operating business would normally do, such as paying taxes on time, remaining in compliance with any real estate lease agreements, maintaining insurance and keeping proper books and records. They also give lenders access to a borrower's financial records. Negative covenants prevent certain actions such as selling assets, making investments in other companies, changing business direction, merging with another company or making major management changes.

Financial Covenants

Typical financial covenants involve measurable items on a company's financial statements. They can include maintaining minimum working capital levels, debt service coverage ratios or maximum debt and leverage ratios. For example, a company with a debt covenant that limits its debt-to-equity ratio to 0.5 would violate that covenant if it took on enough debt to bring its debt-to-equity ratio to 0.6. Financial covenants can also limit a company's distributions in the form of dividends or share buybacks.

Considerations

Violating a debt covenant could result in a loan default and could require a borrower to pay off a loan sooner than expected. Borrowers must carefully monitor their debt covenants to ensure they are in compliance. In some circumstances, a lender will grant a waiver on a debt covenant if it believes the borrower will still be able to make her loan payments. Borrowers should maintain open communication with their lenders to catch any problems early.

References

• The RMA Journal: Staying Informed: Monitoring Loan Covenants; Darren D. Lydting; July-August 2007
• The RMA Journal: An Overview of Covenants in Large Bank Loans; John K. Paglia; March 2002
• BABM Business Magazine: What Lies Beneath: Understanding Debt Covenants and their Impact on your Company; Mariem Talavera; 2010
• Private Equity Law Review: Affirmative and Negative Covenants; Geoffrey Parnass, Esq.; 2007