What are Debt Covenants?
Debt covenants are formal agreements or promises that are made between different parties like creditors, suppliers, vendors, shareholders, investors, etc and a company that states the limits for financial ratios such as leverage ratios, working capital ratios, dividend payout ratios, etc which a debtor must refrain from breaching.
Ideally, when the lenders lend the money to the borrowers, they sign an agreement. And under this agreement, the borrowers have to maintain certain restrictions so that the interest of the lenders is protected.
Debt covenants (Bond Covenants) can be called by many names. Two of the popular names are banking covenantsCovenantsCovenant refers to the borrower's promise to the lender, quoted on a formal debt agreement stating the former's obligations and limitations. It is a standard clause of the bond contracts and loan agreements. and financial covenants. Actually, they all mean the same thing.
Why are debt covenants necessary?
In other words, why bond covenants lenders would restrict the borrowers from doing something? The bond covenant lenders don’t want to pressurize the borrowers with rules and restrictions. However, if they don’t bind the borrowers with few terms & conditions, they may not get their money back.
It is also important to note that debt covenants also help the borrowers (yes, even after being restricted). When the agreement between the borrowers and the lenders is signed, the terms & conditions are discussed. And if the borrowers abide by the terms, they may need to pay a lower interest rate (cost of the borrowing) to the lenders.
Debt Covenants Example
Let’s say that Icebreaker Co. has taken debt from a bank. The bank has offered the company a $1 million loan stating that until the company pays off the bank the principal plus a 10% interest, the company won’t be able to take any additional loan from the market.
The restriction imposed by the bank on Icebreaker Co. would be called a bond covenant. But why the bank would do such a thing? Let’s analyze it.
- First of all, the bank would do its own due diligence before lending the amount to the Icebreaker Co.
- If the bank finds that Icebreaker Co. doesn’t have a good risk-profile, lending a big amount would be risky too for the bank. In this case, if the company goes out and also borrows a million here and another million there and goes belly up, the bank will not get back its money.
- Thinking about the future risk, the bank may restrict the company from borrowing any additional loan until the loan of the bank is being paid off in full.
Bond Covenants Metrics
How do the lenders get to know what bond covenants they need to impose upon the borrower? Here are some metrics that the lenders/borrowers need to look at before imposing bond covenants.
- Total assets: A company that has good enough AUM (Assets under Management) would have good financial health (at least on the surface). To know whether a company can pay off its debts, the lenders need to look at the next ratio.
- Debt / Assets: This is a simple ratio that every lender needs to look at before lending any money to the borrower. This ratio helps the investor understand whether the company has enough assets to pay off the debts. For example, if they have lower total assets than debts, the company has a big problem. Or else if the company has a pretty lower debt (i.e., 10% of total assets), the company may be playing too safe.
- Debt / Equity: Even if the equity shareholders would get paid after the debt-holders would get their money, still it’s important for the investors to know the debt-equity ratioDebt-equity RatioThe debt to equity ratio is a representation of the company's capital structure that determines the proportion of external liabilities to the shareholders' equity. It helps the investors determine the organization's leverage position and risk level. of the company. By looking at the ratio, they would be able to see how much debt and how much equity the company has taken and what’s the risk of debt-holders to lose out.
- Debt / EBITDA: This is one of the most important metrics the lenders should look at. Since EBITDA is the earnings before the interest, taxes, depreciation, and amortizationAmortizationAmortization of Intangible Assets refers to the method by which the cost of the company's various intangible assets (such as trademarks, goodwill, and patents) is expensed over a specific time period. This time frame is typically the expected life of the asset., EBITDA can really show whether a company has the financial stability to pay off the debt (principal plus interest) in due time.
- Interest Coverage Ratio: This is another measure that is so very important. The interest coverage ratio compares the EBIT/EBITDA with interest. The higher the ratio better would be for the lenders. If the ratio is lower, the lenders may need to think about offering a loan to the company.
- Dividend Payout Ratio: Why is this ratio even important? It’s because the dividend pay-out ratio decides how much dividends the company would declare at the end of the year. If the dividend payout is too high, it may enhance the risk of the lenders. That’s why one of the most common debt covenants is restricting the borrower from paying a huge dividend.
Positive Debt Covenants
Positive debt covenants are things that the borrowers must do to ensure that they get the loan. Below is a Positive bond Covenant example.
Other positive debt covenants example
- Aim a specific range of certain financial ratio: positive debt covenants is important for the lenders to know that they’re protected. To ensure that the lenders may ask the borrowers to reach a specific range for certain financial ratiosFinancial RatiosFinancial ratios are indications of a company's financial performance. There are several forms of financial ratios that indicate the company's results, financial risks, and operational efficiency, such as the liquidity ratio, asset turnover ratio, operating profitability ratios, business risk ratios, financial risk ratio, stability ratios, and so on. to avail the loan.
- Ensure the accounting practices are as per GAAP: This is a basic ask, but an important one. The lenders must ensure that the borrowers are adhering to the Generally Accepted Accounting Principles (GAAP)(GAAP)Generally accepted accounting principles (GAAP) are the minimum standards and uniform guidelines for the accounting and reporting. These standards prohibit firms from engaging in unethical business activities and enable for a more accurate comparison of financial reports to investors..
- Present yearly audited financial statements: positive debt covenants lenders must ensure whether the financial statementsFinancial StatementsFinancial statements are written reports prepared by a company's management to present the company's financial affairs over a given period (quarter, six monthly or yearly). These statements, which include the Balance Sheet, Income Statement, Cash Flows, and Shareholders Equity Statement, must be prepared in accordance with prescribed and standardized accounting standards to ensure uniformity in reporting at all levels. are accurate and represent the right picture of the company’s financial affairs. That’s why a yearly audit will definitely help.
Negative Debt Covenants
Negative debt covenants are the things the borrowers can’t do. Below is a negative bond covenant example.
Other negative debt covenant examples
- Don’t pay cash dividends over a certain extent: If a firm gives away the majority of its earnings in cash dividendsCash DividendsCash dividend is that portion of profit which is declared by the board of directors to be paid as dividends to the shareholders of the company in return to their investments done in the company. Such a dividend payment liability is then discharged by paying cash or through bank transfer., how would it pay off the money they owe to the lenders? That’s why the lenders impose a restriction on the borrowers that they can’t pay cash dividends over a certain extent.
- Don’t take an additional loan: negative debt covenants are a borrower shouldn’t take more loans before they pay off the due of the lenders. It helps protect the interest of the lenders.
- Don’t sell specific assets: Negative debt covenants lenders may also restrict the borrowers from selling certain assets until the debt is being paid off in full. Doing so will compel the borrowers to generate more earnings to pay off the debt. The negative debt covenants will protect both the lenders and the borrowers in the long-run.
Video on Debt Covenants
This has been a guide to what are debt covenants. here we discuss the positive and negative bond covenants along with its metrics like total assets, debt to assets, debt to EBITDA, debt to equity, interest coverage ratio, and dividend payout ratios. You may also go to other articles on Corporate Finance –