What is a covenant?
A covenant is a promise on the part of businesses that borrow money to uphold certain conditions stated in its loan agreement. They’re meant to protect the creditor from risk associated with lending. Covenants compel borrowers to maintain their physical assets and forbid them from taking certain actions that could affect their assets’ level of equity.
Even if the borrowing company continues to make its payments against the loan on time, the company may perform certain actions that jeopardize its ability to pay back the loan in the future. To protect itself from that risk, the lender may ask the creditor to enter into a covenant, which helps dictate the terms under which a business remains eligible for a loan. These terms describe the health of the company under different metrics.
Usually, covenants include maximum debt-to-equity ratios that the company must observe. Lenders calculate this ratio by dividing any debt a company owes by the amount of equity the company owns. Lenders may also predicate a covenant on financial projections like a current ratio or its borrower’s ability to pay taxes on time.
Covenants can require a business to take out a certain amount of insurance as well as prescribe what business liens are permitted. In what’s called a negative loan covenant, creditors limit how much a company can owe at any given times and establish the payment schedule for dividends, if any are offered. Covenants may require permission for a merger, acquisition, or divestiture as well as further investments in capital.
If a covenant is broken, the lender has the right to extract penalties from the borrower, including enforcing its obligation or restricting further access to the business’s line of credit. This can also affect the company’s credit rating or stock price.
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Purple Taurus is a small energy drink company. They’re taking out a commercial loan in the hope of expanding their operations. The bank who issues the loan requests that they sign a covenant which states that a minimum amount of revenue must be reinvested in the company. They also can’t spend any amount of revenue buying out their competitor, Green Cow, without the bank’s explicit approval. Purple Taurus signs the covenant and the bank issues the loan.