Debt Covenants

Debt covenants are formal agreements or promises that are made between different parties like creditors, suppliers, vendors, shareholders, investors, etc, and a company that states the limits for financial ratios such as leverage ratios, working capital ratios, dividend payout ratios, etc which a debtor must refrain from breaching. The parties involved are required to follow the debt covenant compliance to avoid legal action.

Ideally, when lenders lend money to borrowers, they sign an agreement. And under this agreement, the borrowers have to maintain certain restrictions so that the interest of the lenders is protected. Debt covenants (Bond Covenants) can be called by many names. Two of the popular names are banking covenants and financial covenants. Actually, they all mean the same thing.

• Debt covenants are contractual agreements between a borrower and a lender that impose certain restrictions, obligations, or conditions on the borrower. These covenants aim to protect the lender's interests by mitigating risks associated with the borrower's financial health and operational decisions.
• Debt covenants can be classified into two main categories: affirmative and negative. Affirmative covenants require the borrower to fulfill specific actions or meet certain financial targets. Negative covenants prohibit the borrower from engaging in certain activities or acts that could increase the lender's risk.
• Debt covenants provide lenders with control mechanisms to monitor the borrower's financial performance, safeguard against potential default or financial distress, and preserve the value of their investment.

Debt covenants are limitations or restrictions placed by lenders on the actions of their borrowers. It might seem like added pressure for the borrower. However, its purpose is to ensure both the lender’s and the borrower’s principles and thought processes are aligned.

In other words, why would bond covenant lenders restrict the borrowers from doing something? The bond covenant lenders don’t want to pressurize the borrowers with rules and restrictions. However, if they don’t bind the borrowers with a few terms & conditions, they may not get their money back.

Source: akelius.com

It is also important to note that debt covenants also help the borrowers (yes, even after being restricted). When the agreement between the borrowers and the lenders is signed, the terms & conditions are discussed. And if the borrowers abide by the terms, they may need to pay a lower interest rate (cost of the borrowing) to the lenders.

There are two major types of covenants, namely, positive and negative. While positive ones determine what the borrower can do, and negative ones determine the restrictions of the borrowers’ actions.

Let us understand the concept of debt covenants ratio with the help of a couple of examples. These examples will give us a practical outlook and implication of the concept and its related factors.

Example #1

Icebreaker Co. has taken debt from a bank. The bank has offered the company a $1 million loan stating that until the company pays off the bank the principal plus a 10% interest, the company won’t be able to take any additional loan from the market.

The restriction imposed by the bank on Icebreaker Co. would be called a bond covenant. But why would the bank do such a thing? Let’s analyze it.

• First of all, the bank would do its own due diligence before lending the amount to the Icebreaker Co.
• If the bank finds that Icebreaker Co. doesn’t have a good risk profile, lending a big amount would be risky too for the bank. In this case, if the company goes out and also borrows a million here and another million there and goes belly up, the bank will not get back its money.
• Thinking about the future risk, the bank may restrict the company from borrowing any additional loan until the loan of the bank is being paid off in full.

Example #2

The Indian Epharmacy unicorn PharmEasy acquired a loan of approximately $285 million or INR 2,280 crores from Goldman Sachs in August 2022 to repay an earlier debt incurred to buy-out Thyrocare.

One of the points in the terms and conditions of the agreement was to raise equity capital of approximately INR 1,000 crores or $120 million through the Initial Public Offering (IPO) that it had planned to put forth in 2023.

Since then, they have delayed their IPO plans to 2025 and have only managed to repay $50 million of their mammoth $285 million.

Since it is a technical default the US-based lender can potentially take over the company and its most profitable branch- Thyrocare, their initial reason for seeking a loan.

As of 2023, PharmEasy’s management is working towards restructuring the loan terms or raise equity funding to ensure the default is settled.

The two branches or types of debt covenants compliance are regarding positive covenants and negative covenants. Let us discuss both these types in detail through the explanation below.

Positive

Positive debt covenants are things that the borrowers must do to ensure that they get the loan. Below is a Positive bond Covenant example.

source: marineharvest.com

Other Examples

• Aim a specific range of certain financial ratio:  positive debt covenants are important for the lenders to know that they’re protected. To ensure that the lenders may ask the borrowers to reach a specific range for certain financial ratios to avail the loan.
• Ensure the accounting practices are as per GAAP: This is a basic task, but an important one. The lenders must ensure that the borrowers are adhering to the Generally Accepted Accounting Principles (GAAP).
• Present yearly audited financial statements: positive debt covenants lenders must ensure whether the financial statements are accurate and represent the right picture of the company’s financial affairs. That’s why a yearly audit will definitely help.

Negative

Negative debt covenants are the things the borrowers can’t do. Below is a negative bond covenant example.

source: marineharvest.com

Other Examples

• Don’t pay cash dividends over a certain extent: If a firm gives away the majority of its earnings in cash dividends, how would it pay off the money they owe to the lenders? That’s why the lenders impose a restriction on the borrowers that they can’t pay cash dividends over a certain extent.
• Don’t take an additional loan: negative debt covenants are a borrower shouldn’t take more loans before they pay off the due of the lenders. It helps protect the interest of the lenders.
• Don’t sell specific assets: Negative debt covenants lenders may also restrict the borrowers from selling certain assets until the debt is being paid off in full. Doing so will compel the borrowers to generate more earnings to pay off the debt. The negative debt covenants will protect both the lenders and the borrowers in the long run.

How do the lenders get to know what bond covenants they need to impose upon the borrower? Here are some metrics that the lenders/borrowers need to look at before imposing bond covenants ratio or other conditions.

• Total assets: A company that has good enough AUM (Assets under Management) would have good financial health (at least on the surface). To know whether a company can pay off its debts, the lenders need to look at the next ratio.

• Debt / Assets: This is a simple ratio that every lender needs to look at before lending any money to the borrower. This ratio helps the investor understand whether the company has enough assets to pay off the debts. For example, if they have lower total assets than debts, the company has a big problem. Or else if the company has a pretty lower debt (i.e., 10% of total assets), the company may be playing too safe.

• Debt / Equity: Even if the equity shareholders would get paid after the debt-holders would get their money, still it’s important for the investors to know the debt-equity ratio of the company. By looking at the ratio, they would be able to see how much debt and how much equity the company has taken and what’s the risk of debt-holders losing out.
• Debt / EBITDA: This is one of the most important metrics the lenders should look at. Since EBITDA is the earnings before the interest, taxes, depreciation, and amortization, EBITDA can really show whether a company has the financial stability to pay off the debt (principal plus interest) in due time.
• Interest Coverage Ratio: This is another measure that is so very important. The interest coverage ratio compares the EBIT/EBITDA with interest. The higher the ratio the better would be for the lenders. If the ratio is lower, the lenders may need to think about offering a loan to the company.
• Dividend Payout Ratio: Why is this ratio even important? It’s because the dividend pay-out ratio decides how much dividends the company would declare at the end of the year. If the dividend payout is too high, it may enhance the risk of the lenders. That’s why one of the most common debt covenants is restricting the borrower from paying a huge dividend.

When the borrower violates the agreed set of actions in the terms and conditions from the lender, it is considered to be a violation. The consequences of these violations can lead to a variety of consequences depending on the terms of agreement. Let us understand how the inability to adhere to debt covenants compliance can affect the borrower through the discussion below.

• The most common penalty for a borrower violating the terms of agreement is a steep decline in their bond’s rating. This makes its significantly lesser attractive for investors and increases the issuer’s costs of borrowing.
• For properties, a violation could attract expensive fines or liens. However, the Homeowners Association (HOA) cannot force the owner to sell the house, they might file for liquidation.
• Depending on the terms, violations can attract fines, penalties, liens, or even more serious legal punishments.

This has been a guide to what are Debt Covenants. Here we explain its examples, violations, and types- positive and negative covenants in detail. You may also go to other articles on Corporate Finance –

• Debt Consolidation Example
• Margin Debt
• Debt vs. Equity
• Negative Covenants