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What are the Financial Covenants?

by Paul Watsdon

 

Financial covenants are the undertakings or agreements written down into by a borrowing customer that are financial in context.). At Reorg, we have dedicated staff tasked with making financial decisions, providing crucial information, and safeguarding clients in an ever-changing business environment 

An example of a financial covenant is when a borrowing company agrees to keep an agreed financial ratio, such as the interest coverage ratio, total assets to debt ratio, or debt to equity ratio. Covenants require borrowers to conform with the terms agreed upon in the loan agreement

Significance of Financial Covenants

Financial covenants serve the purpose of a security net for the lender to monitor and control the borrower’s financial activity. They are usually put by the bank or creditor as a tool to reduce the risks associated with disbursed bank’s money. 

Through covenants the lender put legal bindings on the borrower, for example, to maintain a certain limit of a ratio or keep a certain level of cash flow, the lender safeguards the safety and security of their lent-out money and shields itself from the risks linked with the loan agreement.

In case there is a breach of a financial covenant the lender has the upper hand and results in the lender gaining the right to call the full loan amount if previously agreed upon, collect collateral against the breach of a covenant agreement, or may charge a higher interest rate on the loan than initially agreed upon.

It’s the discretion of the lender to waive Financial covenants. They can be either temporary or permanent. It entirely depends on the lender, and the borrower is usually powerless when it comes to the waiver decision.

Examples of Financial Covenants

To sustain a certain debt to equity ratio

To sustain a certain interest coverage ratio

To sustain a certain level of cash flow

To sustain a minimum level of earnings before interest, tax, and depreciation (EBITD)

To sustain a minimum level of earnings before interest and tax (EBIT)

To sustain a certain level of operating expenses

Advantages of Financial Covenants

For the Borrower

Trust: In matters of money trust is the vital factor. Financial covenants are a means of getting the trust of the lender. Signing the covenant agreement, the lending party is warranted that there is security against the risks linked with a loan agreement.

Stability in financial performance: When the borrower is legally bound to sustain certain ratios or maintain a certain level of cash flow, due to financial covenants, it is also safeguarding financial stability for itself.

For the Lender

Security: One core benefit of financial covenants to the lender is that it is a security measure to protect the lender from losing the lent-out money. Financial covenants are used as a security measure to guarantee there is enough cash liquidity or stability with the borrower so that they can pay back the loan.

Control: Financial covenants are undertakings given by the borrowing party. Through the agreements, the lender maintains the upper hand, as they have full control over the lending terms and conditions.

Rights: Through financial covenants, the lender is well protected. In case of violation of a financial covenant agreement/contract, the lender has the right to call the full loan amount if previously agreed upon, collect collateral, or may charge a higher interest rate on the loan than initially agreed upon.