Types of Debt or Loan covenants and its impact

Consider you giving your car to your bestie with checklists to take care of. It may include To-Do List like keeping a petrol tank full, obeying traffic rules (positive debt covenants). It may also include Not To Do list like No rash driving, No drink & drive (negative debt covenants). Similarly, a Debt or Loan Covenant is a formal debt agreement between a lender and borrower implying certain obligations that needs to be met by the borrower. In other words, a debt covenant or loan covenant is a set of rules framed by the lender for the borrower to follow it religiously.

Any form of debt comes with predetermined obligations. Debt comes at the cost of premium price charged by borrower to the lender for having him use that debt since lender wanted to use it desperately. It can also be defined as a promise to take certain actions (affirmative covenants) or to refrain from taking certain actions (negative covenants)

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Debt impacts

Positive & Negative Debt Covenants

Positive debt covenants state what the borrower must do and may include the following:
  • Maintain certain minimum Financial ratios
  • Maintain accounting records in accordance with GAAP
  • Provide audited financial statements
  • Maintain all facilities in good working condition
  • Pay taxes and other liabilities when due
Positive and negative debt covenants finmargin
Positive/Negative Debt Covenants
Negative debt covenants state what the borrower cannot do and may include the following:
  • Pay cash dividends exceeding certain threshold
  • Sell certain assets
  • Enter into certain types of leases

Over time, the restrictions are relaxed by the lender if below conditions are met by the borrower-

  • Improved business results
  • Paid down substantial part of its debt

May corporates especially during Acquisitions, Mergers or Amalgamations undertake such Debt or Loan Covenant laid out by the lender in return for the funds given. They need to abide by such covenants until they pay back all the borrowed money. During that tenure the lender may relax some of the obligations laid upon the borrower provided the financial condition of the borrower improves and it has never defaulted in making the payments.

FunFacts

  • Most of the companies have revisited their Debt Covenants in mid of 2020. This was done to ensure they meet the clauses while asking to relax some of the them in anticipation of struggling revenues due to Covid-19

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