What are “Covenants”?

A covenant is a promise in any formal debt agreement, that certain activities will or will not be carried out or that certain thresholds will be met. Covenants in finance most often relate to terms in a financial contract, such as a loan document or bond issue stating the limits at which the borrower can further lend. Covenants are often put in place by lenders to protect themselves from borrowers defaulting on their obligations.

Key Learning Points

  • Covenants exist in financial contracts, such as bond issues, which ensure that certain activities will or will not be carried out.
  • Covenants often include a timeline and a list of supporting documents required to show the borrower has met the conditions of the loan.
  • Covenants are legally binding and if breached, will set off compensatory or other legal action.
  • Covenants that allow certain activities are considered affirmative, while restrictive ones are called negative covenants.
  • Covenants are reviewed at least once a year and maybe adjusted, should conditions change.

Covenants explained

Covenants are usually represented in terms of financial ratios that must be maintained, such as a maximum debt-to-asset ratio or other such ratios. Covenants can cover everything from minimum dividend payments, to levels that must be maintained in working capital and key employees remaining with the firm. Once a covenant is broken, the lender typically has the right to call back the obligation from the borrower. Generally, there are two types of covenants included in loan agreements: affirmative covenants and negative covenants.

Negative Covenants

Negative covenants are put in place to make borrowers refrain from certain actions that could result in the deterioration of their credit standing and ability to repay existing debt. The most common forms of negative covenants are financial ratios that a borrower must maintain as of the date of the financial statements.

Affirmative Covenants

An affirmative covenant is a clause in a loan contract that requires a borrower to perform specific actions. Examples include requirements to maintain adequate levels of insurance or produce audited financial statements to the lender, compliance with applicable laws and maintenance of proper accounting books and credit rating. A violation of an affirmative covenant can result in outright default.

Financial Covenants

Financial covenants are promises or agreements entered into by a borrowing party that are financial in nature.  The two financial covenants included in most debt terms sheets are the Earnings Before Tax Depreciation] and Amortization (EBITDA) based leverage and the interest cover ratio.

The EBITDA based leverage ratio is calculated as follows:

(Net debt/EBITDA)

Where:

Net debt=Total interest-bearing liabilities – Highly liquid financial assets

The interest coverage ratio is calculated as follows:

(EBITDA/interest expense)

Example:

Please calculate the net debt leverage and the interest cover for ABC plc. Check if the company is investment grade, which would be the case for a net debt leverage ratio of below 3.5x and an interest cover ratio of above 9x.

net debt leverage calculation