Debt Covenants

Brief Definition

Debt covenants are conditions or restrictions set by lenders in a loan agreement to protect their interests. These covenants are designed to ensure that the borrower maintains certain financial and operational standards.
If the borrower violates these covenants, it may result in penalties, higher interest rates, or even the loan being called due immediately.

Further Explanation

Debt covenants are conditions or restrictions set by lenders in a loan agreement to protect their interests. These covenants are designed to ensure that the borrower maintains certain financial and operational standards. There are two main types of debt covenants: affirmative covenants and negative covenants. Affirmative covenants require the borrower to do specific things, such as maintaining a certain level of insurance or submitting regular financial statements. Negative covenants restrict the borrower from engaging in certain actions, like taking on additional debt or selling significant assets without the lender’s approval. If the borrower violates these covenants, it may result in penalties, higher interest rates, or even the loan being called due immediately.

Example:
A company takes out a loan from a bank, which includes a covenant requiring the company to maintain a debt-to-equity ratio of no more than 2:1. If the company’s debt exceeds this ratio, it will be in violation of the covenant, and the bank may impose penalties or demand immediate repayment of the loan.