Debt covenant

Debt Accounting covenants, also called banking covenants or financial covenants, are
agreements between a company and its creditors that the company should operate within
certain limits.

The conditions agreed to vary. A company may, for example, agree to limit other
borrowing or to maintain a certain level of gearing. Other common limits include levels
of interest cover, working capital and debt service cover.

Debt covenants are agreed as a condition of borrowing. They may be changed if debt is
restructured. Debt covenants can impose quite heavy obligations — a company may well
be forced to sell assets in order to stay within a debt covenant on gearing. Even an equity
cure is significant action to be forced into.

The purpose of debt covenants is to ameliorate a common agency problem. Equity

holders (who appoint the management) can benefit by making the business riskier, to the
detriment of creditors. Alternatives to debt covenants include the use of convertible debt,
the issue of warrants bundled with debt, and the use of shorter term debt.

In theory, breach of a debt covenant usually allows creditors to demand immediate

repayment. This rarely happens in practice. The debtor is not usually in a position to
make an immediate repayment. A breach of covenants therefore usually leads to a
renegotiation of the terms of debt. The debt is likely to be re-negotiated on worse terms
as a quid pro quo for not demanding immediate repayment.

In order to prevent companies from meeting the requirements by adjusting their

accounting practices rather than by genuinely maintaining the required level of financial
health, debt covenants not only specify the numbers that should be met, but also exactly
how they should be calculated for the purposes of the debt covenant.

This means that if a company breaches, or is in danger of breaching, its debt covenants,
not only does this indicate that the company is not financially strong, but also that the
problems are likely to become worse as lenders react.

(Gearing, called leverage in the US and some other countries, measures the extent to
which a company is funded by debt. One common definition is:

debt ÷ shareholders funds

Unfortunately, there are other definitions, and the other that is widely used (which many
people find easier to understand intuitively) is:

debt ÷ capital employed

which is the same as:

debt ÷ (debt + shareholders' funds)

Regardless of the definition, and there are variations even on debt/equity, it is usual to
show gearing as a percentage rather than a fraction.

Debt includes only borrowing, not other debt such as trade creditors. It is not unusual to
subtract goodwill from the value of shareholders' funds when calculating gearing.
Although this is not universally done, it is logical as goodwill reflects a company's
history rather than its current financial strength.

As a general rule debt/equity of more than 100% or debt/capital employed of more than
50% is "high", but there is no cut-off point that is too high. As debt gets higher, profits
for shareholders become more volatile for the same reasons as with operational gearing.

A high level of debt is a cause for concern, but it does accelerate profit growth as well as
declines. Companies with more stable operating profits can safely take on higher levels of
debt, so what is acceptable depends on the business.

Interest cover is a more direct measure of the effect of gearing on the volatility of
profits.)

What is a loan covenant?

Business loan article
Loan covenant definition:

A condition that the borrower must comply in order to adhere to the terms in the loan
agreement. If the borrower does not act in accordance with the covenants, the loan can be
considered in default and the lender has the right to demand payment (usually in full).

Why do banks add covenants to the loan agreements

Banks usually add covenants in order to accomplish the following objectives:

Maintain loan quality

Keep adequate cash flow
Preserve equity
In a borrower with a known weakness in its capital structure as a measure to
improve this weakness
Keep an updated picture of the borrower’s financial performance and condition

Common loan covenants

Things that the borrower must do
Hazard Insurance / Content Insurance

The borrower is required to keep insurance coverage on the plant / equipment or

inventory in order to safeguard against the catastrophic loss of collateral

Key-man life insurance

Insures the life of the indispensable owner or manager without whom the company could
not continue. The lender usually gets an assignment of the policy.

Payment of taxes / fees / licenses

Borrower agrees to keep those expenses up to date as failure to pay would result on the
assets of the company being encumbered by a lien from the government, which would
take precedence to the one from the bank.

financial information on borrower and guarantor

Borrower agrees to submit financial statements for the continuing assessment by the
bank. Financial statements are usually submitted yearly, while account receivable can be
required every month.

Minimum financial ratios

The borrower is required to maintain a certain level in key financial ratios such as:

Minimum quick and current ratios (liquidity)

Minimum Return on Assets and Return on Equity (profitability)
Minimum equity, minimum working capital and maximum debt to worth (leverage)

Other loan covenants

Things that the borrower can not do

In addition, the borrower might be prevented from doing certain things via loan
covenants.
No change of management or merger without prior approval.

Guarantees the continuing existence of your borrower and will impede the
deterioration of financial condition due to merger with an unknown entity

No more loans without prior approval

Assures that the company does not take on excessive debt affecting the quality of the
original loan.

No dividends/withdrawals or limited dividend withdrawals

In situations where the net worth is being eroded by the extraction of capital in the
form of dividends or stockholder’s withdrawals. The lender might find it necessary
to restrict the amount of money that can be taken out of the company. In
subchapter-S corporations it is not uncommon to limit withdrawals to the owner’s
tax liability.

Article
Ref (The Information Content of Bank Loan
Covenants)
We find that riskier firms and firms with fewer investment opportunities select tighter financial
covenants.

Prior empirical work on the structure of loan covenants has chiefly focused on the determinants
of specific contract provisions such as collateral requirements.1 This literature primarily examines
the role of covenants in mitigating manager/shareholder incentives to engage in value reducing
risk shifting.2 Since the agency costs of debt are generally thought to be inversely related to the
financial condition of the firm, covenants are expected to be more restrictive in loan contracts of
the least creditworthy borrowers (e.g., highly levered firms and firms with significant growth
opportunities). Loans to observationally riskier firms may also have tighter covenants because
tighter covenants provide lenders the option to reassess the loan and take action for even modest
deteriorations in performance.

Where covenants are set may depend on the borrower’s risk characteristics and
investment opportunities as well as on private information concerning future changes in
the borrower’s covenant variable and contracting parties’ expectations concerning the
likelihood and impact of a covenant violation. Therefore, by examining whether covenant
tightness is related to future changes in the borrower’s covenant variable, operating
performance, investment and financial policies, and the outcome of covenant violations,
we can gain important insights into the nature of the information conveyed by covenant
threshold choice.
First, there is a large theoretical literature in banking that focuses on banks as screeners that
reduce ex ante information asymmetries (see, for example, Diamond (1991), Fama (1985), and
Ramakrishnan and Thakor (1984)). This literature suggests that as part of the due diligence
process in underwriting commercial loans or as part of an ongoing lending relationship banks
obtain access to material nonpublic information concerning the borrower’s risk and future
prospects. Indeed, the use of this type of nonpublic information in granting loans and in
monitoring borrowers is often used to distinguish bank lending from “arm’s length” funding
arrangements (see Rajan (1992)). Thus, where covenant thresholds are set may inform other
market participants about the bank’s expectations concerning the riskiness and future prospects of
a borrower.

Third, since covenant violations are impactful on borrowers, tight covenants provide risky
borrowers incentives to improve the covenant variable to avoid technical defaults. So long as
covenants are the product of negotiations between borrowers and lenders in which the borrower
has some choice, the selection of tight covenants can convey information about the borrower’s
costs and/or benefits of working hard.

Anecdotal evidence also suggests that the choice of covenants conveys information about the
borrower’s expected future prospects. For example, Zimmerman (1975) states that through the
loan document and the covenants it contains, “…the bank creates a clear understanding to the
borrower as to what is expected”

Also, firms might select tight covenants when they have few investment opportunities (i.e., when
the cost of constraining them is low), so they reduce investment spending and borrowing ex post,
which results in improvements in their covenant variable. Alternatively, tighter covenants may
provide stronger incentives for riskier borrowers to improve performance or borrowers may use
tight covenants to signal favorable private information concerning future performance (in
exchange for more favorable loan terms).

We also examine the relationship between the borrowing firm’s stock price reaction to loan
announcements and the restrictiveness of the covenants contained in the loan agreement. If
selection of tight covenants conveys to “arm’s length” investors favorable private information
concerning the borrower’s risk and/or performance, tight covenants would be associated with
greater announcement returns. Alternatively, tighter covenants may be associated with higher
returns due to closer bank monitoring and heightened prospect of lender intervention that might
help reduce the severity of managerial agency problems.

Finally, covenant tightness might serve as a proxy for unobservable borrower risk and loan
announcements may be associated with greater stock returns for risky firms as the announcements
eliminate uncertainties regarding the firm’s bankability.

First, we can examine changes in performance along a narrow but presumably value relevant
measure. Second, it seems reasonable that covenant selection conveys information that is closely
tied to future performance as measured by changes in the covenant variable because borrowers
and lenders determine covenant thresholds that they expect can be achieved

• the minimum EBITDA requirements

• the minimum current ratio covenant and the maximum Debt/EBITDA covenant.