Say why debt covenants exist and what they do
The idea
Covenants are contractual restrictions a borrower accepts in exchange for cheaper credit. Affirmative covenants require actions - maintaining insurance, supplying financial statements, keeping a ratio above a threshold. Negative covenants forbid them: additional borrowing beyond a limit, asset sales, dividends above a level. Their purpose is to restrain the risk-shifting incentive that leverage creates, since shareholders capture the upside of a gamble while lenders bear much of the downside. Breaching one usually triggers a default even when every payment has been made on time, which is why covenant headroom is monitored as closely as liquidity.
Formulas
Lender tests: leverage and interest cover
L = D ÷ EBITDA and ICR = EBIT ÷ I
- L
- the leverage ratio
- ICR
- the interest cover ratio
- D
- total borrowings
- EBITDA
- earnings before interest, tax, depreciation and amortisation
- EBIT
- earnings before interest and tax
- I
- the yearly interest bill
Covenants usually cap the first ratio and set a floor under the second. Breaching either lets the lender act.
A practice question
Why would a company voluntarily restrict what it may do with its own assets?
- To obtain credit more cheaply than otherwise - correct
- To obtain a longer maturity on the debtWhy not: Maturity is negotiated as a separate term; what covenants buy is a lower interest cost.
- To reduce the tax it pays on its interestWhy not: Interest is deductible whether or not covenants are attached.
A covenant is a promise in a loan agreement that limits what the borrower may do. It protects the lender, because it lowers the chance of losing money. A safer loan can carry a lower interest rate. Formula: Interest rate = Risk-free rate + Credit spread, and covenants shrink the spread. The borrower gives up some freedom, for example agreeing not to sell its main plant, in exchange for cheaper credit. A company that expects to behave prudently anyway loses little by making the promise.
A harder one
Which is an example of a negative covenant?
- A requirement to supply audited accounts quarterlyWhy not: An affirmative covenant: it requires the borrower to do something rather than refrain from it.
- A restriction on paying dividends above a specified level - correct
- A requirement to maintain insurance on pledged assetsWhy not: Also affirmative, and among the most common obligations of that kind.
A covenant is a rule written into a loan agreement. A negative covenant says what the borrower must NOT do, while an affirmative covenant says what the borrower MUST do. Limiting dividends above a set level is a prohibition, so it is negative. It stops cash leaking out to shareholders and away from lenders. Supplying audited accounts and keeping insurance on pledged assets are things the borrower must do, so they are affirmative.
The hardest tier
Why is covenant headroom monitored alongside liquidity?
- Because covenants determine the interest rate chargedWhy not: Some agreements ratchet the margin with a ratio, which is a pricing feature rather than the reason headroom is watched.
- Because a cash-rich company can still fail a ratio test - correct
- Because covenants are tested every dayWhy not: Testing is usually quarterly, at the reporting date.
Covenant headroom is how far the company is from breaking a covenant limit. Liquidity is whether it has cash to pay its bills. They are different tests. Formula: Debt / EBITDA must stay below the limit. For example, if earnings fall sharply, the ratio can pass the limit even though the bank balance is large, and the lender may then be entitled to call the loan, meaning demand repayment. So a cash-rich company can still lose its funding. Both tests matter, since failing either can end access to funds.
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