Debt covenants are restrictions that lenders (creditors, debt holders, investors) put on lending agreements to limit the actions of the borrower (the debtor). In other words, debt covenants are agreements between a company and its lenders that the company will operate within certain rules set by the lenders. They are also called banking covenants or financial covenants.
The Purpose of Debt Covenants
Debt covenants are not used to place a burden on the borrower. Rather, they are used to align the interests of the principal and agent, as well as solve agency problems between the management (borrower) and debt holders (lenders).
Debt covenant implications for the lender and the borrower:
Debt restrictions protect the lender by prohibiting certain actions by the borrowers. Debt covenants restrict borrowers from taking actions that can result in a significant adverse impact or increased risk for the lender.
Debt restrictions benefit the borrower by reducing the cost of borrowing. For example, if lenders are able to impose restrictions, lenders will be willing to impose a lower interest rate for the debt to compensate.
Reasons Why Debt Covenants are Used
Note that in the scenarios below, it is in the best interest of both parties to set debt covenants. Without such agreements, lenders may be reluctant to lend money to a company.
Lender A lends $1 million to a company. Based on the risk profile of the company, the lender lends at an annual interest rate of 7%. If there are no covenants, the company can immediately borrow $10 million from another lender (Lender B).
In this scenario, Lender A would set a debt restriction. He’s calculated an interest rate of 7% based on the risk profile of the company. If the company turns around and borrows more money from additional lenders, the loan will be a riskier proposition. Therefore, there will be a higher possibility of the company defaulting on its loan repayment to Lender A.
Lender A lends $10 million to a company. In the following days, the company declares a liquidating dividend to all shareholders.
In this scenario, Lender A will set a dividend restriction. Without the restriction, the company can pay out all of its earnings or liquidate its assets and pay a liquidating dividend to all shareholders. Therefore, the lender would be out of his or her money if the company were to liquidate the company and pay out a liquidating dividend.
List of Debt Covenants
Below is a list of the top 10 most common metrics lenders use as debt covenants for borrowers:
- Debt / EBITDA
- Debt / (EBITDA – Capital Expenditures)
- Interest Coverage (EBITDA or EBIT / Interest)
- Fixed Charge Coverage (EBITDA / (Total Debt Service + Capital Expenditures + Taxes)
- Debt / Equity
- Debt / Assets
- Total Assets
- Tangible Net Worth
- Dividend Payout Ratio
- Limitation on Mergers and Acquisitions
Positive vs Negative Covenants
Debt covenants are defined as positive debt covenants or negative debt covenants. Although it is defined as either “positive” or “negative,” a “positive” debt covenant does not imply a good debt covenant, while a “negative” debt covenant does not imply a bad debt covenant.
Positive debt covenants are covenants that state what the borrower must do. For example:
- Achieve a certain threshold in certain financial ratios
- Ensure facilities and factories are in good working condition
- Perform regular maintenance of capital assets
- Provide yearly audited financial statements
- Ensure accounting practices are in accordance with GAAP
Negative debt covenants are covenants that state what the borrower cannot do. For example:
- Pay cash dividends over a certain amount or predetermined threshold
- Sell certain assets
- Borrow more debt
- Issue debt more senior than the current debt
- Enter into certain types of agreements or leases
- Partake in certain M&A
Example of a Debt Covenant
Let us consider a simple example. A lender enters into a debt agreement with a company. The debt agreement could specify the following debt covenants:
- The company must maintain an interest coverage ratio of 3.70 based on cash flow from operations
- The company cannot pay annual cash dividends exceeding 60% of net earnings
- The company cannot borrow debt that is senior to this debt
Violation of Debt Covenants
A debt covenant violation is a breach of contract. When a debt covenant is violated, depending on the severity, the lender can do several things:
- Demand penalty payment
- Increase the predetermined interest rate
- Increase the amount of collateral
- Demand full immediate repayment of the loan
- Terminate the debt agreement
– Corporate Finance Institute