What are Financial vs Non-Financial Covenants?
Comparing financial vs non-financial covenants in a loan agreement helps us to better understand how agreements are formulated and the way they are executed across various industries. Covenants are a type of promise that exists in contract law and are a part of many borrowing agreements throughout corporate and personal finance.
What are Financial Covenants?
Financial covenants are aspects of an agreement (generally loans) that limit or provide restrictions on how a company or individual operates their finances. A financial covenant can stipulate how much debt a company can take on or even how stringent financial ratios must be maintained as a part of such an agreement. Financial covenants, by their very definition, revolve around the financial aspects of an agreement or contract.
What are Non-Financial Covenants?
Non-financial covenants come with many of the complementary aspects to an agreement that do not discuss finances. They are a critical part of financial agreements that help guide the terms of a contract, as well as provide barriers for one or either party to operate between. It helps to ensure the faithful execution of the contract that occurs in good faith by the two signing parties.
Side by Side Comparison
|Financial Covenants||Non-Financial Covenants|
|Part of a contract||✔|
|Financial in nature||✔|
|Regulate the adoption of more loans||✔|
|Borrower cannot change business model||✔|
|No physical assets of the company can be destroyed||✔|
|Compliance with all local laws||✔|
|Compliance with all local financial laws and regulations||✔||✔|
Understanding the Contract You Sign!
Understanding the difference between a financial and non-financial covenant can help you to be a more informed borrower and put you in a stronger position to negotiate. By understanding where you or your business can be limited under certain agreements, you can negotiate more favorable terms to increase your likelihood of success.
You, as a signatory and business owner, understand the direction you are trying to take your company and how certain limitations may impede growth and perhaps even set you up for failure in the future. Negotiating the financial and non-financial covenants can help you when deciding which institution to borrow from in order to help bring together a more favorable deal for you or your business.
The nuances of contract negotiation are important and a critical facet of being an effective manager or entrepreneur. Negotiating from a place of strength allows one to be able to understand the way that the agreements they sign are formed and anticipate the restrictions of any “fine print” that may exist within an agreement or contract that they sign. Understanding the difference between financial and non-financial covenants is central to the process.
CFI is the official provider of the global Commercial Banking & Credit Analyst (CBCA)™ certification program, designed to help anyone become a world-class financial analyst. To keep advancing your career, the additional resources below will be useful: