What are Financial Covenants?
Financial covenants are the promises or agreements entered into by a borrowing party that are financial in nature. An example of a financial covenant is when a borrowing company agrees to maintain (staying above or below) an agreed ratio, typically financial ratios such as the interest coverage ratio, total assets to debt ratio, or debt to equity ratio. Covenants require borrowers to comply with the terms agreed upon in the loan agreement.
- Financial covenants are promises or agreements entered into by a borrowing party that are financial in nature.
- Covenants are promises or agreements entered into by a borrowing party to comply with the terms agreed upon in relation to a loan agreement.
- A very basic example of a financial covenant is when the borrowing company agrees to maintain (staying above or below) an agreed financial ratio, such as the interest coverage ratio, total assets to debt ratio, or debt to equity ratio.
Importance of Financial Covenants
Financial covenants serve the purpose of a safety net for the lender. They are usually undertaken by a lender as a measure to reduce the risks associated with lending their money. By making it legally binding for the borrower to maintain a certain limit of a ratio or keep a certain level of cash flow, the lender ensures the safety and security of their lent-out money and protects itself from the risks associated with the loan agreement.
Usually, the breach of a financial covenant results in the lender gaining the right to call the entire loan amount, collect collateral (if previously agreed upon) in exchange for the breach of a covenant agreement, or charge a higher interest rate on the loan than previously agreed upon.
Financial covenants may be waived upon the discretion of the lender. They can be either temporary or permanent. However, it entirely depends on the lender, and the borrowing party is usually powerless regarding the waiver decision.
Examples of Financial Covenants
- Maintaining a certain debt to equity ratio
- Maintaining a certain interest coverage ratio
- Maintaining a certain level of cash flow
- Maintaining a minimum level of earnings before interest, tax, and depreciation (EBITD)
- Maintaining a minimum level of earnings before interest and tax (EBIT)
- Maintaining a certain level of operating expenses
Advantages of Financial Covenants
For the Borrower
Financial covenants are a means of gaining the trust of the lender. In this way, the lending party is ensured that there is security against the risks associated with a loan agreement.
2. Stability in financial performance
When the borrower is legally bound to maintain certain ratios or keep a certain level of cash flow, owing to financial covenants, it is also ensuring financial stability for itself.
For the Lender
One major advantage of financial covenants to the lender is that it can be used as a security measure to protect the lender from losing the amount that they have lent out. Financial covenants are usually used as a security measure to make sure there is enough cash flow or stability with the borrowing party so that they are able to pay back the loan.
Financial covenants are undertakings that the lender asks for in return for lending the money to the borrowing party. The agreements usually end up with the lender having the upper hand, as they have control over the lending situation.
The lender is well protected when financial covenants are in place for a loan arrangement. This is because on violation of a financial covenant agreement/contract, the lender has the right to call the entire loan amount, collect collateral (if previously agreed upon) in exchange for the breach of a covenant agreement, or charge a higher interest rate on the loan than previously agreed upon, and so on.
Disadvantages of Financial Covenants
For the Borrower
1. Limiting and restrictive
Financial covenants can be limiting and restrictive for the borrowing party, as they can hinder the economic or financial freedom of the borrower. In order to maintain a certain ratio level or cash flow, the borrowing party’s operations may be highly limited or restricted.
2. Risk of violation
When a party borrows funds, they usually do it to finance some of their operations for which they do not have enough money themselves. Financial covenants restrict the borrowing party’s financial freedom as they are not able to spend as much as they may have planned to, exposing them to high risk of violation, which can result in incurring bigger losses than expected.
For the Lender
1. Not foolproof
Although such a covenant acts as a security measure, it is not always a foolproof plan. Even though it gives the lender certain rights, it cannot stop an impending default from happening.
CFI offers the Financial Modeling & Valuation Analyst (FMVA)™ certification program for those looking to take their careers to the next level. To keep learning and developing your knowledge base, please explore the additional relevant CFI resources below: