Glossary - Financial Covenant
A financial covenant is a clause in a loan or bond agreement that obligates the borrower to meet specified financial metrics. These can include minimum financial thresholds such as earnings, liquidity ratios, or debt levels. The primary purpose of financial covenants is to ensure that the borrower maintains a certain level of financial stability and performance throughout the term of the loan or bond, protecting the lender's or bondholders' interests.
Also known as
- Debt covenants
- Covenant-lite loans (when such covenants are minimal or absent)
Use cases examples
- Loan Agreement: The borrower must maintain a minimum interest coverage ratio of 1.5x as measured on the last day of each fiscal quarter.
- Bond Indenture: The issuer shall not incur additional secured debt if the fixed charge coverage ratio falls below 2.0x.
Considerations for investors
- Financial covenants provide a form of protection for the investment by monitoring the financial health of the borrower or issuer.
- Investors should assess the reasonableness of the covenant thresholds to ensure they do not unduly restrict the company's ability to operate and grow.
Considerations for founders
- Understanding the restrictions imposed by financial covenants is crucial for operational planning and financial management.
- Violating a financial covenant can lead to default under the agreement, potentially giving lenders the right to demand immediate repayment or enforce penalties.
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