A debt service covenant is a clause designed to test the ongoing financial capacity of a borrower. If a borrower violates a debt service covenant, it can be a sign that the company is in financial trouble. This is an indicator that the borrower can become a financial risk for the bank. Once a covenant violation is identified, the penalty will depend on the severity of the breach.
Debt covenants are outlined in two documents -- the commitment letter and the loan agreement. The lender sends a commitment upon approval of the loan. It details the requirements to close the deal. There will be a section dealing specifically with covenants and the penalty for violations. The loan agreement is a document signed at closing. In this document, the borrower agrees to abide by the terms set forth by the lender. This includes a section on covenants and the criteria to meet them.
Debt covenants are usually tested upon receipt of updated financial information. In the loan agreement, the lender will require the borrower to submit financials on a regular, usually annual, basis. When the financials are received, the analyst and loan officer review them. The analyst will spread the financial statements. This means they will use a program or spreadsheet to analyze the income statement and balance sheet. Once the financials are spread, they will use the necessary information to test the covenant ratio.
Violation occurs when the ratio from the financial statements is lower or higher (depending on the type of covenant) then the ratio indicated in the documents. For example, a borrower must maintain a debt service coverage ratio of 1.20 times. This means that a borrower must show the capacity to pay all of his debt 1.20 times based on his income. The analyst will add net income, interest expense, depreciation, amortization and extraordinary items. He will divide that figure by the sum of interest expense (if not included in the debt), current maturities of long term debt and current capitalized leases. If the resulting number is less than 1.20, the borrower is in violation of his covenant.
The penalty for violating a debt covenant depends on the lender and the severity of the violation. If an otherwise pristine borrower misses the ratio by 0.01, the lender will likely not charge a penalty. If a troubled borrower is well below the ratio, the lender may exercise its rights as outlined in the loan agreement. Potential penalties include fines, rate increases or a declaration of default.