Debt covenant

Debt 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.

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