Source: BURSA MALAYSIA | Published: July 2024
Financing covenants, also known as debt covenants or loan covenants, are contractual agreements
between borrowers (usually companies) and lenders (such as banks or notes holders). These covenants outline specific
conditions and restrictions that the borrower must adhere to during the term of the loan or debt / note issuance.
Let’s explore the key aspects of financing covenants:
1. Types of Financing Covenants
a. Affirmative Covenants
These require the borrower to take specific actions or maintain certain conditions. Examples
include:
- Financial Reporting: Regularly providing financial statements to the
lender.
- Maintenance of Collateral: Ensuring that pledged assets remain in good
condition.
- Compliance with Laws: Adhering to legal and regulatory requirements.
b. Negative Covenants
Negative covenants restrict certain actions by the borrower. Common examples include:
- Debt Limitations: Restricting additional borrowing beyond specified
levels.
- Dividend Restrictions: Limiting dividend payments to shareholders.
- Asset Sales: Controlling the sale of significant assets.
2. Purpose of Financing Covenants
- Risk Mitigation: Lenders use covenants to reduce credit risk. They ensure
that borrowers maintain financial stability.
- Protecting Lender’s Interests: Covenants safeguard lender’s investments
by preventing actions that could harm repayment prospects.
- Monitoring and Communication: Covenants facilitate ongoing communication
between borrowers and lenders.
3. Financial Ratios and Metrics
Lenders often use specific financial ratios to set covenants. Common ones include:
- Debt-to-Equity Ratio: Limits the borrower’s leverage.
- Interest Coverage Ratio: Ensures sufficient earnings to cover interest
payments.
- Current Ratio: Maintains short-term liquidity.
4. Breach and Consequences
If a borrower violates a covenant, it’s considered a breach. Consequences may include:
- Default: The lender can demand immediate repayment.
- Higher Interest Rates: Higher Interest Rates.
- Loss of Collateral: Lenders may seize pledged assets.
5. Negotiating Covenants
During loan negotiations, borrowers and lenders discuss and agree on covenant terms. It’s
essential for borrowers to understand the implications and negotiate reasonable terms.
Conclusion
Financing covenants serve as a crucial risk management tool in lending. Borrowers must carefully
assess their ability to comply with covenants before entering into loan agreements. For lenders, effective
monitoring ensures the borrower’s financial health and minimizes default risk.
Tags: Fixed Income, Investment Notes, Financing, Covenants, Private Markets, Loans, Debt, Credit Investing
