Debt covenants are certain statements in the agreement of a loan which restrict the borrower from doing certain things. The objective of such covenants is nothing but protecting the interest of the lender who is a bank in case of term loans. Also known as restrictive covenants, they are classified as negative covenants (related to asset, liability, cash flow, and control) and positive covenants in relation to certain types of additional reporting to a lender.
These covenants can broadly be classified between positive/affirmative and negative from the point of view of a borrower. We will first look at negative covenants which are of main concern while entering into the contract. Also known as restrictive covenants, these are further classified into various subcategories based on their impact areas such as asset, liability, cash-flow, and control.
Table of Contents
Restrictive / Negative Debt Covenants
Asset Related Restrictive Covenants
These covenants put certain restrictions on the assets of the borrower. The borrower either cannot break these covenants or would need to take due approval or permission before breaking. These restrictions may be in the form of following:
- Creation of any further charges on the assets.
- Sale of fixed assets.
Liability Related Restrictive Covenants
These covenants restrict any activity affecting the liability of the company which may include
- Taking up an additional loan.
- Repayment of existing loan.
- Issue additional equity shares.
- The issue of deposit certificates or unsecured loans etc.
- Any disposal or reduction in promoter’s shareholding.
Cash Flow Related Restrictive Covenants
These covenants restrict the usage of the cash flow of the company.
- Capital expenditure on new projects, expansion, diversification, modernization etc.
- Dividend payment
- Limitation on top management salaries etc.
Control Related Restrictive Covenants
Covenants on control are very embarrassing for the management because it directly impacts the way they have managed the company prior to the debt.
- Selection of management team and bringing organizational change in consultation with the bank or financial institution.
- Appointment of Nominee Directors.
Affirmative / Postive Covenants
These covenants are called affirmative or positive covenants because they do not put any restriction on anything but normally impose certain additional task to the borrower.
- Submission of financial statements from time to time as agreed in the loan agreement.
- Maintenance of certain working capital level and net worth of the company.
- Secure debt payment by maintaining sinking fund.
What not have you to do for obtaining and maintaining that loan in the company? Taking money from a financial institution is not so easy. Borrowers lose all their freedom. But, if we think from the point of view of the bank or financial institution, who is holding public money with it, has to do such due diligence before handing over that money to anybody. They have to make sure that the loan does not become bad debt.
M. Y. Khan and P. K. Jain. Financial Management, 5th Edition, TATA McGraw HILL.