Understanding Debt Covenants

Debt covenants (also referred to as loan covenants) are important components of the legal loan agreement between a borrower and a lender. They exist to protect the lender from risks associated with loaning funds, and to define the terms of the loan agreement so that there is complete clarity between the borrower and the lender. Debt covenants are both affirmative and negative (more on this later) and failure to comply with the covenants can lead to an event of default. Common covenants can include both operational and financial components (more on this later, too.) 

Debt covenants are also sometimes called financial covenants.

What is a Debt Covenant?

Broadly speaking, a covenant is a promise made between two parties. In the case of debt covenants, this promise is a legally binding agreement contained in the loan agreement executed by both the borrower and the lender. This occurs when an entity, usually a company, takes out a loan from a financial institution. The purpose of the loan agreement is to protect the lender and to provide guidance to the borrower on expected behavior and company performance.

Affirmative Debt Covenants

Affirmative or Positive covenants are those things the borrower agrees to do. Common affirmative covenants include periodically and timely providing financial statements, maintaining equipment or facility standards, keeping good accounting practices, paying taxes, complying with laws and regulations, etc. 

In the debt covenant agreement, affirmative covenants make up their own section. There are often many individual affirmative covenants within a single agreement, and the borrower must abide by all of them. Below are some examples of affirmative debt covenants, from a real agreement.

Affirmative Debt Covenant Examples

1. Insurance: the borrower must agree to insure all property of an “insurable nature,” including equipment, real estate, and fixtures and inventories. The insurers must be “financially sound and reputable.”
2. Payment of taxes: the borrower must pay all taxes.
3. Location of collateral, borrower name and state of organization: the borrower must keep all collateral aside from inventory in transit and motor vehicles at the set forth locations. The borrower should not remove any collateral from said locations except for inventory sold in the normal course of business. The borrower will not change its legal name and trade names without giving the bank 30 days prior written notice. The borrower agrees not to change its state of incorporation or organization.

Negative Debt Covenants

As you may expect, negative debt covenants regulate things the borrower must not do to remain in the loan— or need prior lender approval to do. This can include borrowing more debt, paying dividends, or selling crucial assets. For example, if the borrower were to sell key assets, this could affect company operations— and therefore compromise their ability to repay the lender. 

Just like for affirmative debt covenants, there is often a section in the formal agreement for negative covenants. Also like for the affirmative side, there are often many negative covenants within a single agreement. Below are a few examples of negative covenants— from a real agreement.

Negative Debt Covenant Examples

1. Debt: the borrower will not create debt other than that which is already permitted.
2. Sale-leasebacks; subsidiaries; new business: the borrower cannot enter into any sale or leaseback transaction with respect to any of its properties or create any subsidiary, or manufacture any goods, render any services or otherwise enter into any business which is not substantially similar to that existing on the Closing Date.
3. Conflicting agreements: the borrower cannot enter into any agreement that has a term or condition conflicting with this agreement.
4. Changes in accounting principles; fiscal year: the borrower must not make any changes to its current accounting principles or methods, except the ones required by GAAP. It must also acquire the bank’s consent to change its fiscal year.

Financial Covenants

Within a formal agreement, there is often a third section: that for financial covenants. These can be thought of as affirmative or negative covenants; in other words, if the borrower must maintain a set debt-to-EBITDA ratio, this is both a positive and negative requirement. The borrower must not go above a certain ratio, which is negative, and must maintain a specified ratio, which is positive. Regardless, these covenants are financial in nature. 

Since poor financial performance could impair the lender’s loan, the lender and borrower agree to a set of defined financial covenants that the lender uses to verify that the company financial performance is satisfactory. Financial covenants are ratios and calculations that are used to show performance and ability to meet interest and principal payment obligations. Examples of common financial covenants include fixed charge coverage ratio, debt to EBITDA multiple, and interest coverage ratio. We elaborate on these examples below.

Net Debt-to-EBITDA Ratio

This ratio compares a company’s net debt to its cash flow. In this instance, cash flow is measured by EBITDA (earnings before interest, taxes, depreciation, and amortization). You can read more about EBITDA here. Using EBITDA to determine cash flow is a good gauge of a company’s financial health. Comparing cash flow to net debt helps determine the likelihood that a company will be able to repay the debt. It is important to remember that this ratio handles net debt, not just debt; net debt is total debt after subtracting cash and cash equivalents. 

So what ratio is a good ratio? This depends on a number of factors, but a general rule of thumb is that a net debt/EBITDA ratio of three or less is considered good, and the lower, the better. On the other hand, ratios higher than this could be a sign of financial stress and lower the company’s likelihood of paying the loan.

Interest Coverage Ratio

The interest coverage ratio is a common financial covenant and can be defined in many ways.  One typical definition might be EBIT (earnings before interest and taxes) divided by total interest payments. This ratio offers insight into a company’s ability to pay interest on its debts. This metric also helps determine how risky it is to lend to a company. The interest in this case is interest due to any loan, or line of credit, or other borrowing.

Fixed-Charge Coverage Ratio (FCCR)

This metric assesses a company’s capability to meet all of its financial obligations. These obligations include interest, principal, taxes, and sometimes capital expenditures. Below is the equation for calculating FCCR.

FCCR= (EBITDA + FCBT)/ (FCBT + i)

In this equation, FCBT stands for fixed charges before tax, while EBITDA is a company’s earnings before interest, taxes, depreciation and amortization. The i represents interest. A high ratio signifies an increased likelihood of being able to make payments, while a low ratio shows the opposite. 

Below is an example of the FCCR part of a debt covenant from a real agreement.

Default: Breach of Contract

If the borrower does not abide by a covenant, the borrower is in technical default. Some defaults are curable— and others are not. For example, if the borrower is supposed to send the lender monthly financial statements 30 days after month end and forgets to do so, this is a technical default, that is cured once the borrower sends the financials to the lender. In general, there are little d defaults and big D defaults. The example above would be a little d default. A big D default, for example, would be failure to pay interest or principal payments when due. Big D defaults generally trigger the lender to take action. The lender could require an immediate, full loan repayment, end the agreement, or increase collateral or interest rates. The lender may also charge a default interest premium.

In Summary

Debt covenants play an important role in leveraged finance. Banks feel comfortable lending to companies because they have certain rights and protections provided in the credit agreement— including covenants. Borrowers are willing to give up certain rights and abide by the restrictions in return for access to the lender’s capital.

If you have any questions about debt covenants, send us a message— we would be happy to help.