Financial Covenants: Definition, Types & Importance

Financial covenants are the promises or agreements entered into by a borrowing party that are financial in nature. An example of a financial covenant is when a borrowing company agrees to maintain (staying above or below) an agreed ratio, typically financial ratios such as the interest coverage ratioInterest Coverage RatioInterest Coverage Ratio (ICR) is a financial ratio that is used to determine the ability of a company to pay the interest on its outstanding debt., total assets to debt ratio, or debt to equity ratioDebt to Equity RatioThe Debt to Equity Ratio is a leverage ratio that calculates the value of total debt and financial liabilities against the total shareholder’s equity.. Covenants require borrowers to comply with the terms agreed upon in the loan agreement.

Summary

• Financial covenants are promises or agreements entered into by a borrowing party that are financial in nature.
• Covenants are promises or agreements entered into by a borrowing party to comply with the terms agreed upon in relation to a loan agreement.
• A very basic example of a financial covenant is when the borrowing company agrees to maintain (staying above or below) an agreed financial ratio, such as the interest coverage ratio, total assets to debt ratio, or debt to equity ratio.

Importance of Financial Covenants

Financial covenants serve the purpose of a safety net for the lender. They are usually undertaken by a lender as a measure to reduce the risksCredit RiskCredit risk is the risk of loss that may occur from the failure of any party to abide by the terms and conditions of any financial contract, principally, associated with lending their money. By making it legally binding for the borrower to maintain a certain limit of a ratio or keep a certain level of cash flow, the lender ensures the safety and security of their lent-out money and protects itself from the risks associated with the loan agreement.

Usually, the breach of a financial covenant results in the lender gaining the right to call the entire loan amount, collect collateralCollateralCollateral is an asset or property that an individual or entity offers to a lender as security for a loan. It is used as a way to obtain a loan, acting as a protection against potential loss for the lender should the borrower default in his payments. (if previously agreed upon) in exchange for the breach of a covenant agreement, or charge a higher interest rate on the loan than previously agreed upon.

Financial covenants may be waived at the discretion of the lender. They can be either temporary or permanent. However, it entirely depends on the lender, and the borrowing party is usually powerless regarding the waiver decision.

Examples of Financial Covenants

• Maintaining a certain debt to equity ratio
• Maintaining a certain interest coverage ratio
• Maintaining a certain level of cash flow
• Maintaining a minimum level of earnings before interest, tax, and depreciation (EBITD)
• Maintaining a minimum level of earnings before interest and tax (EBIT)EBIT GuideEBIT stands for Earnings Before Interest and Taxes and is one of the last subtotals in the income statement before net income. EBIT is also sometimes referred to as operating income and is called this because it's found by deducting all operating expenses (production and non-production costs) from sales revenue.
• Maintaining a certain level of operating expenses

Advantages of Financial Covenants

For the Borrower

1. Trust

Financial covenants are a means of gaining the trust of the lender. In this way, the lending party is ensured that there is security against the risks associated with a loan agreement.

2. Stability in financial performance

When the borrower is legally bound to maintain certain ratios or keep a certain level of cash flow, owing to financial covenants, it is also ensuring financial stability for itself.

For the Lender

1. Security

One major advantage of financial covenants to the lender is that it can be used as a security measure to protect the lender from losing the amount that they have lent out. Financial covenants are usually used as a security measure to make sure there is enough cash flow or stability with the borrowing party so that they are able to pay back the loan.

2. Control

Financial covenants are undertakings that the lender asks for in return for lending the money to the borrowing party. The agreements usually end up with the lender having the upper hand, as they have control over the lending situation.

3. Rights

The lender is well protected when financial covenants are in place for a loan arrangement. This is because on violation of a financial covenant agreement/contract, the lender has the right to call the entire loan amount, collect collateral (if previously agreed upon) in exchange for the breach of a covenant agreement, or charge a higher interest rate on the loan than previously agreed upon, and so on.

Disadvantages of Financial Covenants

For the Borrower

1. Limiting and restrictive

Financial covenants can be limiting and restrictive for the borrowing party, as they can hinder the economic or financial freedom of the borrower. In order to maintain a certain ratio level or cash flow, the borrowing party’s operations may be highly limited or restricted.

2. Risk of violation

When a party borrows funds, they usually do it to finance some of their operations for which they do not have enough money themselves. Financial covenants restrict the borrowing party’s financial freedom as they are not able to spend as much as they may have planned to, exposing them to high risk of violation, which can result in incurring bigger losses than expected.

For the Lender

1. Not foolproof

Although such a covenant acts as a security measure, it is not always a foolproof plan. Even though it gives the lender certain rights, it cannot stop an impending default from happening.

Additional Resources

CFI offers the Certified Banking & Credit Analyst (CBCA)®Program Page - CBCAGet CFI's CBCA™ certification and become a Commercial Banking & Credit Analyst. Enroll and advance your career with our certification programs and courses. certification program for those looking to take their careers to the next level. To keep learning and developing your knowledge base, please explore the additional relevant CFI resources below:

• CreditworthinessCreditworthinessCreditworthiness, simply put, is how "worthy" or deserving one is of credit. If a lender is confident that the borrower will honor her debt obligation in a timely fashion, the borrower is deemed creditworthy.
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