Covenant explained

A covenant, in legal and financial terms, is a commitment made in an indenture or other formal debt arrangement that specific acts will be carried out or that certain thresholds will be fulfilled. Covenants in finance are clauses in a financial contract, such as a loan instrument or a bond issuance, that specify the maximum amount a borrower can lend.

Covenant process

Covenants are sometimes expressed in terms of required financial ratios, such as a maximum debt-to-asset ratio or other similar ratios. Covenants can encompass everything from minimum dividend payments to working capital levels that must be maintained to the retention of essential workers.

When a covenant is breached, the lender normally has the authority to call the borrower’s debt back. In most loan agreements, there are two sorts of covenants: affirmative covenants and negative covenants.

Types of covenants

Affirmative Covenants

A positive covenant, also known as an affirmative covenant, is a phrase in a loan contract that mandates a borrower to take particular acts. Affirmative covenants include requirements to maintain acceptable levels of insurance, to provide the lender with audited financial accounts, to comply with relevant laws, and to keep accurate accounting books and credit ratings, if applicable.

Negative Covenants

Negative covenants are used to compel debtors to refrain from doing specific acts that might harm their credit score and capacity to repay current debt. Financial ratios that a borrower must maintain as of the date of the financial statements are the most typical types of negative covenants. Most loan agreements, for example, stipulate that the ratio of total debt to a certain measure of profits not exceed a set threshold, ensuring that a firm does not take on more debt than it can pay.

Benefits of a covenant

• Financial contracts, such as bond offerings, contain covenants that specify which actions will or will not be carried out.
• Covenants are legally enforceable terms that, if broken, can result in monetary damages or other legal action.
• Affirmative covenants enable certain actions, but negative covenants limit them.