What are debt covenants?

June 4, 2012

Learn about debt covenants and their classification (positive and negative, capital and performance). Understand actions when debt covenants are violated, including financial reporting implications. Review an example of debt covenants involving interest coverage ratio and fixed charge coverage ratio.

1. Definition of debt covenants, positive and negative covenants

Debt covenants are restrictions in debt agreements (indentures) that aim to protect the lender (creditor, debt holder, or investor) by restricting the activities of the borrower (debtor).

Debt covenants benefit both the lender and the borrower:

  • debt restrictions could protect the lender by requiring or prohibiting certain activities of the lender: in other words, debt covenants should restrict the borrower from making decisions that would be detrimental to the lender; and
  • debt restrictions could benefit the borrower by reducing the cost of borrowing (e.g., through lower interest rates and higher credit ratings).

Debt covenants do not aim to place a burden on the borrower. Debt covenants are used to solve the agency problems among the management (i.e., of the borrowing company), debt holders, and shareholders that arise due to the differences in the objectives of the borrower and the lender.

Debt covenants can be either positive or negative.

Negative debt covenants state what the borrower cannot do and may include the following:

  • Incur additional long-term debt (or require that additional borrowing be subordinated to the original indenture)
  • Pay cash dividends exceeding certain threshold
  • Sell certain assets (e.g., sell accounts receivable)
  • Enter into certain types of leases
  • Combine in any way with another firm (i.e., business combinations)
  • Compensate or increase salaries of certain employees

Positive debt covenants state what the borrower must do and may include the following:

  • Maintain certain minimum financial ratios
  • Maintain accounting records in accordance with generally accepted accounting principles
  • Provide audited financial statements (normally within a specified amount of time after fiscal year-end)
  • Perform regular maintenance of real assets used as collateral
  • Maintain all facilities in good working condition
  • Maintain life insurance policies on certain key employees
  • Pay taxes and other liabilities when due
  • Cross-default covenant (when the borrower is in default on any debt to any lender, the borrower is considered to be in default on all debts)

The most common financial ratios used in debt covenants include the following: debt to cash flow, interest coverage, fixed charge coverage, tangible net worth, net worth, debt to tangible net worth, debt service coverage, leverage ratio, current ratio, senior debt to cash flow, cash interest coverage, debt to equity, etc.

In the above listed ratios, the same term can have different meanings in different debt agreements. For example:

  • Debt: total debt, funded debt, funded debt less cash, etc.
  • Cash flow: cash from operations, EBIT, EBITDA, etc.
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