Covenants

A formal debt agreement amendment in an indenture that is entered by a borrowing party or individual to proclaim which activities may or may not be carried out.

Covenants, usually referred to as financial covenants, will include the promises and agreements a borrowing party needs to agree upon concerning that of a loan agreement.

Here are some examples of how covenants work.

Because financial covenants are considered legal agreements, the borrowing company or individual will need to maintain a specific financial ratio.

These financial ratios will be determined by the creditor or lender, but in most instances, the borrowing company will need to peak above or below a certain financial benchmark. These benchmarks can include the total assets to debt ratio, debt to equity ratio, or interest coverage ratio.

What is the importance of a financial covenant?

The financial covenant was introduced to ensure lenders are protected from the associated risks when lending money to an unknown borrowing company. The purpose of the financial covenant, as mentioned, creates a legally binding agreement that puts the security and safety of the lender at hand.

To include a financial covenant in a debt agreement, the lender puts forth certain benchmarks the borrowing company will have to meet to ensure principal payments and interest payments can be made.

What happens when a financial covenant is breached?

Both parties involved in the debt agreement will have previously agreed on collateral that will be stated in the financial covenant. If a borrowing company can not make repayments or breaches the financial covenant, the lender can legally recall the full loan amount to be repaid or collect collateral from the borrowing company.

Breaching a financial covenant can tarnish the reputation of the borrowing company, but also put them at risk to be denied any future financial loans.

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