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What Are Debt Covenants & How Do They Work?

What Are Debt Covenants & How Do They Work?
Sulaiman Abdur-Rahman
Sulaiman Abdur-RahmanUpdated January 4, 2022
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Debt covenants are written agreements between financial lenders and borrowers that may restrict or guide the business activities of a borrower as a condition of receiving a loan or line of credit. A debt covenant, also known as a bank covenant or financial covenant, can require businesses to meet certain performance benchmarks and prohibit businesses from incurring additional debt. Lenders may repossess and sell a company’s assets or obtain some of the cash flows generated by the asset if a company violates the terms of a debt covenant.Borrowers and lenders can mutually agree to covenant terms as part of a loan agreement. Such agreements may contain debt covenants calling for a company’s total debt not to exceed a predetermined ratio of earnings before interest, taxes, depreciation and amortization (EBITDA). Corporations, including small and midsize businesses, may have debt covenants with creditors or investors. Below we provide more details about debt covenants and explain how they work in the business world.

Debt Covenants, Defined

As mentioned above, debt covenants are written agreements between a lender and borrower that may restrict or guide the actions of a borrower as a condition of a loan agreement. When a business borrows money, a financial covenant in the loan agreement may establish rules or expectations governing debt repayments.For example, a bank covenant may require a company’s earnings to meet a certain threshold relative to debt, a performance benchmark that can help evaluate whether a company has a healthy balance sheet. Small businesses often rely on loans as a critical source of capital.Loan terms for small businesses may include debt covenants spelling out possible consequences if the business fails to maintain solid performance as measured by a predetermined accounting ratio. A borrower may disclose any required debt covenant targets and debt covenant realizations in corporate filings.

How Debt Covenants Work

Debt covenants work by giving lenders the authority to oversee a borrower’s business activities as a condition of a loan agreement. Borrowers are expected to make regular debt repayments, and the lender has the authority to enforce any and all debt covenants. Businesses under a debt covenant must abide by the terms spelled out in the contract. Such bank covenants may define financial standards for the company to meet or restrict businesses from undertaking certain activities during the life of the loan.

What Is the Purpose of a Debt Covenant?

The purpose of a debt covenant is to protect lenders from the possible risk of a payment default while giving borrowers access to credit on the promise they will meet certain conditions.A bank covenant helps ensure that each party to the agreement has something to gain from the lender-borrower relationship, such as sufficient capital for the borrower and receipt of principal and interest for the lender. Entrepreneurs, for example, may accept the terms of a debt covenant as a condition of obtaining loans without collateral to help create a business venture.

What Happens if a Debt Covenant Is Violated?

A borrower can face serious consequences for violating the terms of a debt covenant, such as the following:
  • The borrower may be required to meet additional collateral requirements 
  • The borrower could face a reduction in credit availability
  • The lender could subject the borrower to a higher interest rate
  • The lender could demand renegotiated loan terms less favorable to the borrower
  • The borrower could be forced to implement job cuts, including managerial turnover
  • The lender could liquidate the borrower’s assets
  • The lender could seize the borrower’s business and auction it to the highest bidder

Why Use Debt Covenants

As mentioned earlier, lenders may use debt covenants in loan agreements to protect themselves from the possible risk of payment default while giving borrowers access to credit on the promise they will meet certain conditions. Here are some pros and cons of bank covenants:

Common Debt Covenants

Here are examples of common debt covenants:

1. Funded Debt-to-EBITDA Ratio 

One of the most common debt covenants is a performance benchmark that may define the maximum ratio of debt a business may carry relative to its corporate earnings before interest, taxes, depreciation, and amortization (EBITDA). A total funded debt-to-EBITDA ratio may establish a ceiling defining how much debt a borrower may carry in relation to corporate earnings. A financial covenant, for example, could include a provision that sets a borrower’s maximum total funded debt-to-EBITDA ratio at 3.75 to 1.

2. Interest Coverage Ratio

A bank covenant may define a minimum interest coverage ratio measuring a company’s consolidated EBITDA to its consolidated interest expense. The Office of the Comptroller of the Currency (OCC), an independent bureau of the U.S. Department of the Treasury, defines interest coverage ratio as a company’s earnings before interest expenses and taxes divided by its interest expense. Creditors can use this ratio to assess a company’s ability to service its debt.

3. Fixed Charge Coverage Ratio

Debt covenants may include a fixed charge coverage ratio, which is the ratio of a borrower’s available earnings to pay fixed charges, such as lease obligations and interest on funded debt. This ratio can help lenders assess a company’s ability to meet its current financial obligations and take on new debt. A company’s fixed charge coverage ratio can be defined as its EBITDA plus fixed charges divided by its fixed charges plus interest expenses.

4. Limitations on Mergers and Consolidations

A bank covenant may place limitations on a company’s ability to initiate mergers and consolidations or the sale of assets. Lenders may impose limitations on mergers and consolidations to help ensure a company maintains its core operations upon receiving a loan.

5. Debt Service Coverage Ratio

A bank covenant may include a debt service coverage ratio, also known as net income to debt service ratio, to assess a company’s ability to pay current debt obligations. Lenders may assess a borrower’s revenue history before approving small business loan applications.

6. Miscellaneous Covenants

Loan agreements may include miscellaneous debt covenants requiring a company to perform certain activities unrelated to its ability to meet debt obligations. A miscellaneous covenant, for example, could require a borrower to submit periodic audited financial statements.

Positive and Negative Covenants

Debt covenants can be classified as positive or negative. A positive covenant, also known as an affirmative covenant, is a mandate requiring a borrower to perform or maintain certain functions, such as preparing quarterly and annual financial statements in accordance with generally accepted accounting principles and complying with all requirements of law. Negative covenants impose restrictions on a company, such as limitations on mergers and consolidations. Lenders may include negative covenants as a condition of startup business loans for bad credit.

The Takeaway

A loan agreement with positive and negative debt covenants can give entrepreneurs access to capital in exchange for providing lenders with influence to monitor and constrain the business. Tight covenants may open the door to frequent violations with potentially severe penalties.Lantern by SoFi helps startups and enterprises find small business loans. Just fill out a simple form and explore Lantern’s network of lenders to compare business loan rates and personal financing options that may best suit your needs.
Photo credit: iStock/Kittinit Yassara
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About the Author

Sulaiman Abdur-Rahman

Sulaiman Abdur-Rahman

Sulaiman Abdur-Rahman writes about personal loans, auto loans, student loans, and other personal finance topics for Lantern. He’s the recipient of more than 10 journalism awards and currently serves as a New Jersey Society of Professional Journalists board member. An alumnus of the Philadelphia-based Temple University, Abdur-Rahman is a strong advocate of the First Amendment and freedom of speech.
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